diff --git a/lib/rscons/environment.rb b/lib/rscons/environment.rb
index 08f450c..f6bad7d 100644
--- a/lib/rscons/environment.rb
+++ b/lib/rscons/environment.rb
@@ -351,18 +351,21 @@ module Rscons
 
     private
 
-    # Expand certain paths that begin with ^/ to be relative to the
-    # Environment's build root, if present
+    # Expand target and source paths before invoking builders.
+    #
+    # This method expand construction variable references in the target and
+    # source file names before passing them to the builder. It also expands
+    # "^/" prefixes to the Environment's build root if a build root is defined.
     def expand_paths!
-      if @build_root
-        new_targets = {}
-        @targets.each_pair do |target, target_params|
-          target_params[:sources].map! do |source|
-            expand_path(source)
-          end
-          new_targets[expand_path(target)] = target_params
+      @targets = @targets.reduce({}) do |result, (target, target_params)|
+        sources = target_params[:sources].map do |source|
+          source = expand_path(source) if @build_root
+          expand_varref(source)
         end
-        @targets = new_targets
+        target = expand_path(target) if @build_root
+        target = expand_varref(target)
+        result[target] = target_params.merge(sources: sources)
+        result
       end
     end
 
diff --git a/spec/build_tests_spec.rb b/spec/build_tests_spec.rb
index 8e24359..3cb5e22 100644
--- a/spec/build_tests_spec.rb
+++ b/spec/build_tests_spec.rb
@@ -498,4 +498,30 @@ EOF
       env.TestBuilder("file")
     end
   end
+
+  it "expands construction variables in builder target and sources before invoking the builder" do
+    test_dir('custom_builder')
+    class MySource < Rscons::Builder
+      def run(target, sources, cache, env, vars)
+        File.open(target, 'w') do |fh|
+          fh.puts <<EOF
+    #define THE_VALUE 678
+EOF
+        end
+        target
+      end
+    end
+
+    Rscons::Environment.new do |env|
+      env["hdr"] = "inc.h"
+      env["src"] = "program.c"
+      env.add_builder(MySource.new)
+      env.MySource('${hdr}')
+      env.Program('program', "${src}")
+    end
+
+    lines.should == ['CC program.o', 'LD program']
+    File.exists?('inc.h').should be_true
+    `./program`.should == "The value is 678\n"
+  end
 end