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Procurement Fraud Schemes - Categories

May 15, 2021

Types of Procurement Fraud Schemes and their Red Flags

Although there are many types of procurement fraud schemes, this discussion focuses on procurement fraud schemes that fall under the following categories:

  • Schemes involving collusion among contractors
  • Schemes involving collusion between contractors and procurement employees
  • Defective pricing schemes in negotiated contracts
  • Schemes in the post-award and administration phase

Collusion among Contractors

Schemes involving collusion among contractors seek to circumvent the competitive bidding process. In these schemes, competitors in the same market collude to defeat competition or to inflate the prices of goods and services artificially. When competitor commit such schemes, the procuring entity is cheated out of its right to the benefits of free and open competition.

The most common forms of collusion between competitors involve the following types of schemes:

  • Complementary bidding
  • Bid rotation
  • Bid suppression
  • Market division

Complementary Bidding

Complementary bidding (also known as protective, shadow, or cover bidding) occurs when competitors submit token bids that are not serious attempts to win the contract. Token bids give the appearance of genuine bidding, but, by submitting token bids, the conspirators can influence the contract price and who is awarded the contract.

Often, conspirators in complementary bidding schemes submit token bids that:

  • Are too high to be accepted
  • Appear to be competitive in price but deliberately fail to meet other requirements
  • Contain special terms that will not be acceptable to the buyer

Bid Rotation

Bid rotation, also known as bid pooling, occurs when two or more contractors conspire to alternate the business among themselves on a rotating basis. Instead of engaging in competitive contracting, the bidders exchange information on contract solicitations to guarantee that each contractor will win a share of the purchasing entity’s business.

Example

Vendors Ace, Binko, and Cooper are up for three separate contracts, and they agree that Ace’s bid will be the lowest on the first contract, Binko’s bid will be the lowest on the second contract, and Cooper’s bid will be the lowest on the third contract. None of the vendors will get all three jobs, but they are all guaranteed to get at least one. Furthermore, because they plan their bids ahead of time, they can conspire to raise their prices.

Additionally, bid rotation schemes might be coupled with a scheme involving an agreement that the winning bidder will award subcontracts to losing bidders. This allows losing bidders to improve their cash flow as they wait for their turn to win. Similarly, losing bidders might receive a percentage of the winning company’s profits.

Bid Suppression

Bid suppression occurs when two or more contractors enter into an illegal agreement whereby at least one of the conspirators refrains from bidding or withdraws a previously submitted bid. The goal of these schemes is to ensure that a particular competitor’s bid is accepted.

Bid suppression schemes, however, can take on other forms. Because many schemes involving collusion among competitors require that a limited number of bidders agree to the conspiracy, price inflation should become apparent if a new or uncooperative bidder enters the competition. To prevent this, conspirators might pay off outside companies to refrain from bidding or withdraw an already submitted bid. Conspirators might also use more forceful means to discourage uncooperative entities from participating in the bidding process. For example, to protect their monopoly, conspirators might fabricate bid protests or coerce suppliers and subcontractors to avoid dealing with non-cooperating companies.

Market Division

Market division (or market allocation) schemes involve agreements among competitors to divide and allocate markets and to refrain from competing in each other’s designated portion of the market. In these schemes, the competitors generally divide the markets according to geographic area (i.e., the competitors take turns on contracts according to the geographic area), or they make divisions based on the customer (i.e., the competitors allocate specific customers or types of customers among themselves).

The result of these schemes is that competing firms will not bid against each other, or they will submit only complementary bids when a solicitation for bids is made by a customer or in an area not assigned to them. The customer thereby loses the benefit of true competition and ends up paying a higher price than would be dictated by fair bidding under normal economic forces.

Corrupt contractors often conceal market division schemes by submitting bids from shell companies (i.e., companies that have no physical presence and generate little independent economic value). Submitting bids from fictitious entities gives the appearance of competition. Furthermore, the real contractor can raise his prices because the other bids are fraudulent and are sure to be higher than his own. In effect, the bids from fictitious suppliers serve to validate the exaggerated quote from the winning contractor.

Red Flags of Schemes Involving Collusion among Contractors

Common red flags of schemes involving collusion among contractors include:

  • The industry has limited competition.
  • The same contractors bid on each project or product.
  • The winning bid appears too high.
  • All contractors submit consistently high bids.
  • Qualified contractors do not submit bids.
  • The winning bidder subcontracts work to one or more losing bidders or to non-bidders.
  • Bids appear to be complementary bids by companies unqualified to perform the work.
  • Some bids fail to conform to the essential requirements of the solicitation documents (i.e., some bids do not comply with bid specifications).
  • Some losing bids were poorly prepared.
  • Fewer competitors than usual submit bids on a project or product.
  • When a new contractor enters the competition, the bid prices begin to fall.
  • There is a rotational pattern to winning bidders (e.g., geographical, customer, job, or type of work).
  • There is evidence of collusion in the bids (e.g., bidders make the same mathematical or spelling errors; bids are prepared using the same typeface, handwriting, stationery, or envelope; or competitors submit identical bids).
  • There is a pattern where the last party to bid wins the contract.
  • There are patterns of conduct by bidders or their employees that suggest the possibility of collusion (e.g., competitors regularly socialize, hold meetings, visit each other’s offices, subcontract with each other, and so on).

Collusion between Contractors and Employees

Often, procurement fraud schemes involve collusion between contractors and the procuring entity’s employees. The manner in which these schemes are perpetrated generally depends on the corrupt employee’s level of influence. The more power a person has over the bidding process, the more likely it is that the person can influence which entity is awarded the contract. Therefore, procurement employees involved in procurement fraud schemes tend to have a good measure of influence on the competitive bidding process.Various types of procurement employees are potential targets for corrupt contractors, including buyers, contracting officials, engineers and technical representatives, quality or product assurance representatives, subcontractor liaison employees, and anyone else with authority over the awarding of contracts.

Frequently, when a vendor bribes an employee of the purchasing organization to help him in a scheme, the cost of the bribe is included in the corrupt vendor’s bid. Therefore, the purchasing company ends up bearing the cost of the illicit payment.

Procurement fraud schemes involving the purchasing entity’s contractors and employees generally include the following:

  • Need recognition
  • Bid tailoring
  • Bid manipulation
  • Leaking bid data
  • Bid splitting
  • Unjustified sole-source awards or other noncompetitive methods of procurement

Need Recognition

Generally, procurement actions begin with the procuring entity making a determination of its general needs. These initial determinations include assessments of the types and amounts of goods or services required to meet the entity’s needs. In need recognition schemes, procurement employees convince their employer that it needs excessive or unnecessary products or services. Accordingly, need recognition schemes occur in the presolicitation phase.

Often, in need recognition schemes, purchasing entity employees receive a bribe or kickback for convincing their employer to recognize a need for a particular product or service.

There are several red flags that might indicate a need recognition scheme. An organization with unusually high requirements for stock and inventory levels might reveal a situation in which a corrupt employee is seeking to justify unnecessary purchases from a certain supplier. Likewise, if an organization’s materials are not being ordered at the optimal reorder point, this should raise a red flag. An employee might also justify unnecessary purchases of inventory by writing off large numbers of surplus items as scrap. As these items leave the inventory, they open up spaces to justify additional purchases. Another indicator of a need recognition scheme is a need that is defined in a way that can only be met by a certain supplier or contractor. In addition, the failure to develop a satisfactory list of backup suppliers might reveal an unusually strong attachment to a primary supplier—an attachment that is explainable by the acceptance of bribes from that supplier.

Other common red flags of need recognition schemes include:

  • The assessment of needs is not adequately or accurately developed.
  • There is no list of backup suppliers for items, spare parts, and services continually purchased from a single source.
  • Estimates are either not prepared or are prepared after solicitations are requested.
  • Items, parts, and services are obtained from a single source.
  • A suspect employee displays sudden wealth, pays down debts, or lives beyond his means.
  • A suspect employee has an outside business.
  • Multiple purchases are made that fall below the threshold limit.
  • Purchases are made without receiving reports.

Bid Tailoring

Bid tailoring schemes (also known as specifications schemes) occur during the presolicitation phase. In these schemes, an employee with procurement responsibilities, often in collusion with a contractor, drafts bid specifications in a way that gives an unfair advantage to a certain contractor.

Again, bid specifications are a list of elements, measurements, materials, characteristics, required functions, and other specific information detailing the goods and services that a procuring entity needs from a contractor. Specifications assist prospective contractors in the bidding process, informing them what they are required to do and providing a firm basis for making bids, and they provide procurement officials with a firm basis for selecting bids.

There are three primary methods used to commit bid-tailoring schemes. One method involves drafting narrow specifications. In these schemes, a corrupt employee tailors the bid specifications to accommodate a vendor’s capabilities and to eliminate other competitors so that the favored contractor is effectively guaranteed to win the contract. For instance, the tailored bid might require potential contractors to have a certain percentage of female or minority ownership. Such a requirement is not illegal, but if it is placed in the specifications as a result of a bribe, then the employee has sold his influence to benefit a dishonest vendor.

A second method involves drafting broad specifications. In these schemes, a corrupt employee of the buyer designs unduly broad qualification standards to qualify an otherwise unqualified contractor.

A third method involves drafting vague specifications. In these schemes, the buyer’s personnel and the contractor collude to write vague specifications or intentionally omit bid specifications. This enables subsequent contract amendments, allowing the contractor to raise the contract’s price.

Some common red flags of bid tailoring include:

  • Weak controls over the bidding process
  • Only one or a few bidders respond to bid requests
  • Contract is not re-bid even though fewer than the minimum number of bids are received
  • Similarity between specifications and winning contractor’s product or services
  • Bid specifications and statements of work are tailored to fit the products or capabilities of a single contractor
  • Unusual or unreasonably narrow or broad specifications for the type of goods or services being procured
  • Requests for bid submissions do not provide clear bid submission information (e.g., no clear time, place, or manner of submitting bids)
  • Unexplained changes in contract specifications from previous proposals or similar items
  • High number of competitive awards to one supplier
  • Socialization or personal contacts among contracting personnel and bidders
  • Specifications developed by or in consultation with a contractor who is permitted to compete in the procurement
  • High number of change orders for one supplier

Bid Manipulation

In bid manipulation schemes, a procuring employee manipulates the bidding process to benefit a favored contractor or supplier. Thus, these schemes occur during the solicitation and evaluation phases.

In short, bid manipulation involves a fraudster who attempts to influence the selection of a contractor by restricting the pool of competitors from whom bids are sought. Therefore, in these schemes, a corrupt vendor persuades a purchasing company employee to ensure that one or more of the vendor’s competitors cannot bid on the contract, thereby improving that vendor’s chances of winning the contract.

Some common ways to commit these schemes include:

  • Using obscure publications to publish bid solicitations
  • Publishing bid solicitations during holiday periods
  • Accepting late bids or falsifying the bid log
  • Altering bids
  • Extending bid opening dates without justification
  • Prematurely opening bids
  • Releasing confidential information
  • Discarding or losing a bid or proposal
  • Disqualifying bids for improper reasons (e.g., voiding bids for alleged errors in specifications)
  • Adding new vendors to the qualified bidder list for no apparent reason
  • Limiting the time for submitting bids so that only those with advance information have adequate time to prepare bids or proposals

A variation of these schemes involves a corrupt sales representative who deals on behalf of a number of potential bidders. The sales representative bribes a contracting official to rig the solicitation process, ensuring that only those companies that the sales representative represents will get to submit bids. Likewise, in some sectors, it is not uncommon for buyers to “require” that bidders be represented by certain sales or manufacturing representatives.

To protect their client’s interest, these representatives might pay a kickback to the buyer. The result of such transactions is that the purchasing company is deprived of the ability to get the best price on its contract.

Some common red flags of bid manipulation schemes include:

  • Weak controls over the bidding procedures are present.
  • There is evidence of changes to bids after they were received.
  • The winning bid is voided for errors and the job is re-bid or awarded to another contractor.
  • An otherwise qualified bidder is disqualified for seemingly arbitrary, false, frivolous, or personal reasons.
  • A procurement employee accepts late bids.
  • The contract is awarded to a non-responsive bidder.
  • Competing bids are lost.
  • Bid deadlines are changed.
  • Despite receiving fewer than the minimum number of bids, the contract is not re-bid.
  • Invitations for bids are sent to unqualified contractors.
  • Invitations for bids are sent to contractors that previously declined to bid.

Leaking Bid Data

Competitive bids are confidential. They are supposed to remain sealed until a specified date when all bids are opened and reviewed by the procuring entity. Accordingly, employees of a procuring entity can leak pre-bid information or confidential information from competing bidders to a favored bidder, giving that bidder an unfair advantage in the bidding process. Thus, in such schemes, the employee does not alter the specifications to suit the vendor; instead, he gives the favored vendor a head start on planning his bid and preparing for the job.

Typically, these schemes involve a corrupt vendor who pays a procurement employee for the right to see the specifications earlier than the competition. Consequently, the person or persons who have access to sealed bids are often the targets of unethical vendors seeking an advantage in the process.

Example

Gifts and cash payments were given to a majority owner of a company in exchange for preferential treatment during the bidding process. The supplier who paid the bribes was allowed to see his competitors’ bids and adjust his own bids accordingly.

Leaking schemes might also involve measures to restrict the time for submitting bids. Because leaking schemes give favored suppliers advance notice of contracts, they are able to develop their bids before their competition. And if a procurement employee also restricts the time for submitting bids, the employee will limit the period bidders have for developing bid proposals, and the supplier with advance knowledge will have an advantage over the competition.

Some common red flags of leaking bid data schemes include:

  • The procuring entity has weak controls over its contracting system.
  • The winning bid is just under the next lowest bid.
  • The winning bid is unusually close to the procuring entity’s estimates.
  • The last party to bid wins the contract.
  • The contract is unnecessarily re-bid.
  • A contractor submits false documentation to get a late bid accepted.
  • Contracting personnel provides information or advice about contracts to a contractor on a preferential basis.

Bid Splitting

In general, procuring entities must use competitive methods for projects over a certain amount. To avoid this requirement, a dishonest employee might break up a large project into several small projects that fall below the mandatory bidding level and award some or all of the component jobs to a contractor with whom the employee is conspiring.

Some common red flags of bid splitting schemes include:

  • Two or more similar or identical procurements from the same supplier in amounts just under upper-level review or competitive-bidding limits
  • Two or more consecutive related procurements from the same contractor that fall just below the competitive-bidding or upper-level review limits
  • Unjustified split purchases that fall under the competitive-bidding or upper-level review limits
  • Sequential purchases just under the upper-level review or competitive-bidding limits
  • Sequential purchases under the upper-level review or competitive-bidding limits that are followed by change orders

Unjustified Sole-Source Awards or Other Noncompetitive Methods of Procurement Noncompetitive methods of procurement, like sole-source contracting, exclude competition; therefore, such methods can be used improperly to eliminate competition and steer contracts to a particular vendor.

Again, sole-source contracting is a noncompetitive procurement process accomplished through the solicitation of only one source, thereby limiting full and open competition. Sole-source contracting is more vulnerable to fraud than competitive methods because it provides a greater freedom for manipulation and collusion with a vendor or contractor; consequently, procurement organizations typically require justification to use this form of procurement. Typically, justification occurs when the goods or services are available only from a single source, when exigent circumstances do not permit delay resulting from a competitive solicitation, or when solicitation is determined inadequate after soliciting a number of sources. Additionally, in cases involving unjustified sole-source awards, the supplier typically charges a much higher price than the company could have obtained through bidding.

Example

A requisitioner distorted the requirements of a contract up for bid, claiming the specifications called for a sole-source provider. Based on the requisitioner’s information, competitive bidding was disregarded and the contract was awarded to a particular supplier. A review of other bids received at a later date showed that certain materials were available for up to $70,000 less than what the company paid in the sole-source arrangement. The employee had helped divert the job to the contractor in return for a promise of future employment.

Some common red flags of unjustified sole-source award schemes include:

  • Frequent use of sole-source procurement contracts
  • High number of sole-source awards to one supplier
  • Requests for sole-source procurements when there is an available pool of contractors to compete for the contract
  • Procuring entity did not keep accurate minutes of pre-bid meetings
  • False statements made to justify noncompetitive method of procurement
  • Justifications for noncompetitive method signed or approved by employees without authority
  • Employee fails to obtain the required review for sole-source justifications
  • Sole-source justifications developed by or in consultation with a contractor who is permitted to compete in the procurement

Defective Pricing Schemes in Negotiated Contracts

Defective pricing arises when contractors intentionally use inaccurate cost or pricing data to inflate costs in negotiated contracts (i.e., the contracting method that permits negotiations between the procuring entity and prospective contractors).

Defective pricing schemes are more limited than other forms of procurement fraud because they primarily occur in negotiated contracts. Typically, procuring entities use negotiated contracting when conditions are not appropriate for competitive, sealed bidding.

Generally, when engaging in negotiated contracting, contractors submit cost or pricing data. Examples of cost or pricing data include information such as vendor quotes or bids, make/buy decisions, known upcoming production changes, already-bargained-for discounts, and so on. In negotiated contracts, contractors can submit defective pricing data to inflate the contract price. A contractor submits defective cost or pricing data when more current, more complete, or more accurate data existed, but was not disclosed to the procuring entity, resulting in an increase in the contract price.

However, it should be noted that not every instance of defective pricing is the result of the contractor’s fraudulent behavior. In fact, defective data might be submitted for various non- fraudulent reasons, such as negligence, accident, incompetence, mistake, and so on.

Methods of Defective Pricing

A contractor can use various defective pricing schemes to increase the cost of the contract and thereby its profits, but generally, defective pricing schemes involve inflated labor costs or inflated material costs. A contractor can inflate labor costs by:

  • Using outdated cost schedules
  • Using lower-wage personnel to perform work at higher rates
  • Using salaried personnel to perform uncompensated overtime
  • Failing to account for learning-curve cost reductions
  • Subcontracting to affiliated companies at inflated rates

A contractor can inflate material costs by:

  • Failing to disclose discounts and credits
  • Using outdated standard costs
  • Using small-quantity costs to price large-quantity purchases
  • Subcontracting to or purchasing from affiliated companies at inflated prices
  • Failing to disclose residual materials inventory
  • Using phantom suppliers to inflate costs
  • Failing to disclose changes in “make or buy” decisions
  • Estimating costs based on invalid cost allocation methods
  • Using unsupported cost escalation factors

Red Flags of Defective Pricing Schemes

The following are general red flags that relate directly to defective pricing schemes:

  • Contractor provides inadequate, inaccurate, or incomplete documentation to support cost proposals.
  • Contractor is late in providing, delays providing, or cannot provide supporting cost or pricing data.
  • Contractor’s cost estimates are inconsistent with its prices (i.e., discrepancy between quoted prices and actual prices).
  • Contractor uses out-of-date pricing information (e.g., outdated cost schedules) in cost proposals.
  • Contractor fails to update cost or pricing data when past activity showed that costs or prices have decreased.
  • Contractor fails to disclose internal documents on discounts, rebates, and so on.
  • Contractor fails to disclose information regarding significant cost issues that reduce proposal costs.
  • Contractor uses vendors or subcontractors during contract performance that are different from the ones named in the proposal or contract.
  • Materials, supplies, or components that the contractor used in production are different than those listed in the proposal or contract.
  • Contractor delays releasing information that could result in price reductions.
  • Evidence of falsifications or alterations of documentation used to support cost calculations.
  • Contractor has unrealistically high profit margins on completed work.
  • Contractor fails to correct known system deficiencies that lead to defective pricing.
  • Unqualified personnel developed cost or pricing data used in contractor’s estimating process.

Performance Schemes

This discussion examines procurement fraud schemes that occur during the award and performance stage of the procurement process, including:

  • Nonconforming goods or services schemes
  • Change order abuse
  • Cost mischarging schemes

Nonconforming Goods or Services

Nonconforming goods or services fraud, also known as product substitution or failure to meet contract specifications, refers to attempts by contractors to deliver goods or services to the procuring entity that do not conform to the underlying contract specifications. Once contractors deliver goods that do not conform to the contract, they bill and receive payment for conforming goods or services without informing the purchaser of the deficiency.

These schemes can involve a wide variety of conduct, but generally they include any deliberate departures from contract requirements to increase profits or comply with contract time schedules.

An unintentional failure to meet contract specifications is not fraud, but it might constitute a breach of contract. But a contractor who knowingly delivers goods or services that do not meet specifications might be guilty of fraud if he falsely represents that he has complied with the contract or deliberately conceals his failure to do so.

Often, contractors substitute goods or services delivered to the purchaser. Substitution is particularly attractive in contracts calling for expensive, high-grade materials that can be replaced by comparable, much less expensive products. Substitutions often involve component parts that are not easily detected. Similarly, the potential for a product substitution case is greatest where the procuring entity relies on contractor integrity to ensure that it gets what it paid for.

This type of scheme can be committed by the contractor acting alone, or it can be facilitated by procurement or inspection personnel as the result of corruption. In nonconforming fraud schemes involving corruption, the dishonest supplier might give gifts or favors to inspectors or pay kickbacks to contracting officials to facilitate the scheme. The supplier would then submit false documentation to conceal it.

A contractor who repeatedly fails to meet contract specifications without corrective action by inspectors or the customer’s supervisory staff might indicate corruption.

A wide variety of fraudulent schemes might involve nonconforming goods or services. Some examples include:

  • Delivering or using products or materials of lesser quality than specified in the underlying contract
  • Substituting products or items for those specified under the agreement
  • Employing less qualified staff than specified in the contract
  • Delivering or using counterfeit, defective, reworked, or used parts
  • Delivering or using materials that have not been tested
  • Falsifying the test results of materials, products, or goods
  • Making false certifications (i.e., statements that parts or materials are new, domestically manufactured, and meet the contract specifications concerning quality and quantity, or that the company is minority owned)

Red flags of nonconforming goods or services schemes

The following is a list of potential red flags for nonconforming schemes:

  • High percentage of returns for noncompliance with specifications
  • Missing, altered, or modified product compliance certificate
  • Compliance certificates signed by employees with no quality assurance responsibilities
  • Materials testing done by supplier, using the supplier’s own personnel and facilities
  • Evidence that test or inspection results were falsified (e.g., documents appear altered or modified, test documents are illegible, signatures on documents are illegible, documents were signed by unqualified or inappropriate personnel, test reports are similar or identical to sample descriptions and test results, and so on)
  • Highest profit product lines have the highest number of material return authorizations or reshipments
  • Discrepancy between product’s description or normal appearance and actual appearance (e.g., a new product appears to be used)
  • Used, surplus, or reworked parts are delivered
  • Delivery of products that appear counterfeit (e.g., product packaging, appearance, and description do not appear genuine, items that are consistently defaced in the same area, items that appear different from each other, and so on)
  • Offers by contractors to select the sample and prepare it for testing
  • Delivery of look-alike goods
  • Unusually high number of early replacements
  • Contractor restricts or avoids inspections of goods or services upon delivery

Detecting nonconforming goods or services schemes

To detect nonconforming schemes, the fraud examiner should, at a minimum, examine the following for red flags:

  • Contract or purchase order specifications
  • Contractor’s statements, claims, invoices, and supporting documents
  • Received product
  • Test and inspection results for the relevant period, searching for discrepancies between tests and inspection results and contract specifications

Additionally, to detect nonconforming schemes, the fraud examiner should:

  • Review correspondence and contract files for indications of noncompliance.
  • Request assistance from outside technical personnel to conduct after-the-fact tests.
  • Inspect or test questioned goods or materials by examining packaging, appearance, and description to determine if the items are appropriate.
  • Segregate and identify the source of the suspect goods or materials.
  • Review inspection reports to determine whether the work performed and materials used in a project were inspected and considered acceptable.
  • Review the contractor’s books, payroll, and expense records to see if they incurred necessary costs to comply with contract specifications.
  • Review the inspection and testing reports of questioned goods or materials.
  • Conduct routine and unannounced inspections and tests of questioned goods or materials.
  • Examine the contractor’s books and manufacturing or purchase records for additional evidence, looking for discrepancies between claimed and actual costs, contractors, etc.
  • Interview procurement personnel about the presence of any red flags or other indications of noncompliance.
  • Search and review external records (e.g., court records, prior complaints, audit reports, investigative reports, media sources) to determine if there is any history of misconduct.

Change Order Abuse

A change order is a written agreement between the procuring entity and the contractor to make changes in a signed contract. Change order abuse is a performance scheme that involves collusion between the contractor and personnel from the procuring entity. In change order abuses, a corrupt contractor submits a low bid to ensure that it wins the contract award, but, after the procuring entity awards the contract, the corrupt contractor increases their price with subsequent change orders. If successful, these schemes will, at the very least, cause the procuring entity to lose any advantage received through the competitive bidding process. Similarly, a dishonest contractor, acting in collusion with contract personnel, can use the change order process to improperly extend or expand contracts and avoid re-bidding. Change orders generally receive less scrutiny than the process used to acquire the underlying contract, making them a popular way to fraudulently access funds or generate funds for kickbacks.

Even though change orders are inevitable and can develop for various reasons (e.g., design error, ambiguous specifications or omissions in specifications, change in scope, weather delays, improvement in time or cost, building code changes, etc.), fraud examiners should view all contract change orders carefully.

Red flags of change order abuse

When a change order occurs, fraud examiners should immediately be concerned about whether the change was accidental or planned. The following list of red flags can help make this determination.

  • Poor contractor internal controls over determining the need for change orders (e.g., management officials fail to ensure that all proposed change orders are necessary for work that was not known or contemplated at the time the contract was awarded)
  • Procurement employee acts outside normal scope of duties
  • Numerous change orders justified on a variety of grounds, including alleged change in prices, inflation, unavailability of specific materials or equipment, and the need to substitute more expensive alternatives
  • Employee of procuring entity approves numerous unexplained or unjustified change orders for the same contractor
  • Repeated pattern of change orders that increases the price, scope, or period of an agreement, issued after the procuring entity awards the contract
  • Questionable, undocumented, or frequent change orders awarded to a particular contractor
  • After contract is awarded, bid specifications that lack detail (the requirements are vague) are clarified by issuing a change order
  • Poorly drafted requests for change orders
  • Pattern of change orders just below threshold limit
  • Employee of procuring entity who is directly involved in both determining requirements and procuring the item
  • High turnover rate among procurement personnel
  • Period of an agreement is extended by change orders instead of re-bidding

Detecting Change Order Abuse

Fraud examiners can detect change order abuse by engaging in the following activities:

  • Examine contract change orders that add new items.
  • Examine contract change orders that increase the scope, quantity, or price of the existing contract.
  • Analyze contract change orders for red flags.
  • Interview complaining contractors, unsuccessful bidders, and procurement personnel about the presence of any red flags.
  • Search and review external records (e.g., court records, prior complaints, audit reports, investigative reports, media sources, etc.) to determine if there is any history of misconduct.

Cost Mischarging Schemes

Cost mischarging schemes, which take place during the performance stage of the procurement process, occur when a contractor charges the procuring entity for costs that are not allowable, not reasonable, or cannot be allocated to the contract directly or indirectly. Often, contractors contend that a cost mischarge was merely a mistake, and the issue as to whether a mischarge was a mistake or a crime often depends on the contractor’s intent. Thus, when investigating cost mischarging schemes, fraud examiners should investigate the issue of intent.

Here are some common methods contractors use to mischarge costs:

  • Charging the same cost to more than one contract
  • Charging nonexistent costs or costs at inflated amounts
  • Charging unallowable costs (e.g., entertainment or advertising) to the contract
  • Charging costs to the wrong category or contract
  • Failing to disclose discounts and credits
  • Using outdated standard costs
  • Colluding with contractors directly to charge high prices and rebating part of the price increase without disclosure
  • Using phantom suppliers to inflate costs
  • Falsifying supporting documentation

Red flags of cost mischarging schemes

Red flags of cost mischarging schemes include:

  • Contractor refuses, delays, or is unable to provide complete supporting data.
  • Contractor’s supporting documents are missing or unavailable for review.
  • Contractor’s supporting documents are of poor quality.
  • Contractor provides different supporting documents for the same item, and unit prices vary widely.
  • There is evidence of falsifications or alterations to supporting data.
  • Contractor fails to submit cost or pricing data that is current, accurate, and complete.
  • Contractor fails to disclose internal documents on vendor discounts.
  • Cost estimates are not consistent with contractor’s prices.
  • Repeated noncompliance with the contractor’s disclosed bidding or estimating practices.
  • Old, outdated standards used to support proposals.
  • Contractor fails to disclose information regarding significant cost issues that will reduce proposal costs.
  • Contractor uses unqualified personnel to develop cost or pricing data used in estimating process.
  • Contractor uses vendors or subcontractors other than those listed in the proposal.
  • Contractor repeatedly fails to disclose bidding or estimating practices.

Types of cost mischarging schemes

Generally, contractors commit one of three types of mischarges:

Accounting mischarges

Accounting mischarges occur when a contractor knowingly charges unallowable costs to the buyer by concealing or misrepresenting them as allowable costs, or by hiding them in accounts, such as office supplies, that are not usually closely audited. A variation of this type of scheme involves circumventing the limits for certain cost categories by charging those expenses to other cost categories that do not have such limits. For example, a contractor might charge bid and proposal costs or independent research and development costs, which are usually cost-based but limited to a fixed amount, to salaries and wages, repairs and maintenance, or other cost categories.

Material mischarges

Occasionally, material costs are mischarged, both as to their reasonableness and their allocability. Material means physical inventory and component deliverables. It includes raw material and purchased parts, as well as subcontractor and intercompany transfers.

In most cases, material cost mischarging is confined to instances involving raw material or interchangeable parts. Mischarges of finished materials are infrequent because the nature of the items limits their use on other contracts. Similarly, mischarging of specialized material is infrequent because the special character of such items makes it impossible for them to go undetected.

Common methods used to mischarge material costs include:

  • Charging material costs incurred on a fixed-price contract to a cost-type contract
  • Applying inappropriate indirect rates to material costs
  • Charging at standard rather than actual rates
  • Making unrecorded transfers of materials to another contract
  • Purchasing excessive materials on one contract and using them on another contract
  • Purchasing materials from a subsidiary or affiliated company at inflated prices
  • Manipulating inventory pricing methods to inflate material values
  • Charging materials from inventory at current high prices rather than the actual lower purchase prices
  • Using small quantity costs to price large quantity purchases
  • Obtaining vendor quotes from high-priced suppliers and purchasing cheaper items elsewhere

Below is a list of red flags of material cost mischarging schemes:

  • Previously delivered items are transferred from ongoing jobs to open work orders.
  • Items scheduled for delivery in the distant future are transferred from ongoing jobs to open work orders.
  • The contractor transfers items at costs that are substantially different (higher or lower) from actual costs.
  • There are mass transfers of items from one job order to various other job orders.
  • Materials, supplies, or components used in production are different than those used in the proposal or contract.
  • The contractor includes unnecessary or obsolete items in proposals.
  • The contractor charges costs to the original job order when there is no physical inventory left on the job site.
  • There is an increase in transfers of items to inventory write-off or a scrap account.
  • The contractor makes transfers to any type of holding account.
  • The contractor does not properly account for the materials.
  • There are initial billings for actual material costs in excess of negotiated costs.
  • Later billings show a downward adjustment in material costs as labor or overhead costs increase.
  • Improper billing costs become apparent.
  • Vague terms are used to bid materials based solely on management’s judgment or rough estimates.
  • The contractor failed to report excess or residual inventory.
  • The contractor gives poor explanations for a high percentage of noncompetitive subcontractor awards.
  • There is no clear audit trail to verify propriety of material charges.
  • Internal controls over the shipping, receiving, and warehouse receipt for goods or services are weak.
  • Weak internal controls allow numerous opportunities to adjust material charges.

Material mischarges can be detected by engaging in the following activities:

  • Examine contract and cost files for red flags.
  • Examine material cost transfers, which can include transfers:
    • From government contracts to commercial
    • Through any type of suspense or holding account
    • From ongoing jobs to jobs not scheduled for delivery until a much later date
    • From prior lot work orders to current or future work orders
    • To inventory write-off accounts
    • To scrap accounts
  • Determine if contract costs have exceeded or are expected to exceed the contract value, because they should not be diverted to other cost objectives.
  • Compare contract charges to determine if materials are properly charged to the job (too much or the wrong materials).
  • Examine materials ordered and charged in excess of contract requirements.
  • Examine seemingly unrelated materials charged on routing slips.
  • Examine material standards not updated over periods when there are improvements in manufacturing technology or product design.
  • Compare material costs over a specific period to identify any unusual changes and determine the reason for the changes.
  • Review the standard and actual costs of materials to determine if any significant differences exist between the two.
  • Investigate the contractor to determine ownership and search for any signs of corruption.
  • Scan the general ledger, accounts receivable subsidiary ledger, and sales journal for unusual adjusting entries.

Labor mischarges

In the performance of contracts, labor costs are typically the most significant costs incurred, and they form the basis for estimating labor for future contracts.

Labor costs are made up of direct labor charges to the contract and indirect labor charges allocated to the contract through a factor or rate. Direct labor charges are contract costs identified specifically with a contract. In general, direct labor costs are calculated by multiplying all project hours with the labor rates, which are based on actual employee wages or represent wages paid, and they are summarized for all employees within the applicable allocation unit. Indirect labor costs are those identified in two or more cost objectives.

Labor mischarging occurs when the contractor charges the procuring entity for work that was not actually performed. Labor costs are more susceptible to mischarging than material costs because, unlike other items of cost, labor is not supported by external documentation or physical evidence to provide an independent check or balance, and employee labor can readily be charged to any contract. Moreover, the only way to ensure that labor costs are charged to the correct account is to actually observe each employee’s work (to determine which contract the employee is working), and then review the accounting records to verify that the employee’s cost is charged to the proper contract.

It should be noted that even though an incorrect labor charge might be an indicator of fraud, it might also be the result of poor business practices or weak internal controls.

Labor costs can be inflated by various means, including:

  • Reporting inflated salaries and consulting fees
  • Using outdated salary and fee schedules
  • Charging lower rate personnel at higher rates
  • Failing to account for learning-curve cost reductions
  • Transferring labor costs from fixed-price contracts to cost-type contracts
  • Falsifying the labor distribution
  • Billing for the type of service performed rather than the actual employee hours spent performing the work
  • Billing for employees’ expenses that were not incurred
  • Fictitious time cards
  • Altering time cards

Common red flags of labor cost mischarging schemes include:

  • Billings not in line with estimates
  • Excessive or unusual labor charges
  • Sudden, significant shifts in labor charge levels
  • Labor charges inconsistent with contract progress
  • Vague or minimal education, credential, and experience qualification requirements for labor hour contract positions
  • Procuring entity personnel who do not review or challenge qualifications of key contractor employees
  • Contractor has high employee turnover rate among procurement personnel
  • Contractor must hire large numbers of personnel quickly
  • Contractor personnel rarely take vacation
  • Significant increases in charges to overhead accounts (e.g., idle time, down time, and non-applied time)
  • Contractor with a mix of cost-type and fixed-price contracts
  • Increased labor hours with no corresponding increases in material used or units shipped
  • Actual hours and dollars consistently at or near budgeted amounts
  • Labor standards not updated after contractor improves its manufacturing technology
  • Unavailable supporting documentation for proposed standards
  • Lost personnel files
  • No audit trail to verify propriety of labor charges
  • Weak internal controls that provide numerous opportunities to adjust labor charges

Labor mischarges can be detected by engaging in the following activities:

  • Examine labor cost records for the presence of red flags.
  • Review audit reports, reimbursement requests, construction reports, engineering reports, and so on.
  • Conduct site visits to verify that selected employees’ labor costs are being properly charged to the work actually being performed.
  • Examine time cards and total the hours expended on the contract, comparing them to the hours billed.
  • Note, in particular, repeated instances or a pattern of labor charges that increase the cost of cost-plus contracts.
  • Review journal entries used to transfer labor costs.
  • Compare labor costs over a specific period to identify any unusual changes and determine the reason for the changes.
  • Review the standard and actual labor rates to determine if there are any significant differences between the two.
  • Calculate the percentage of total direct labor charged to each contract to determine which had the highest percentage of direct labor charges.
  • Review and compare the labor distribution summaries with payroll records to determine whether the total labor distributions agree with the total labor charges.
  • Compare the direct and indirect labor account totals from the prior year to the current year and note the percentage change.
  • Determine the percentage of total direct labor charged to each contract or work order to reveal which charge numbers had the highest percentage of direct labor charges.
  • Analyze the labor charges to determine if there were any shifts in charging patterns.
  • Prepare a schedule of salary or wage changes and compare it to contract award dates and labor rates.
  • Look for terminated employees who are charged to contracts.
  • Compare employee personnel records to contract position qualification requirements.
  • Interview individuals who changed their charging patterns during the year.
  • Search and review external records (e.g., court records, prior complaints, audit reports, investigative reports, media sources, etc.) to find any history of misconduct.

 

 

 

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