While it may seem cliché to say, “The only constant is change,” that phrase often conjures groans of frustration from contractors in the building construction industry. While changes have become an inevitable — and, at times, necessary — part of the construction process, submitting change orders for acceptance and receiving prompt payment on them can be a significant challenge that negatively impacts a contractor’s profitability. The size and number of changes on a particular project can substantially alter final costs and schedules, not to mention increase risk. If handled improperly, changes can lead to distrust between parties that, in some cases, results in detrimental disputes and litigation.
The single most common area of dispute in the change order process is cost. Among cost-related disputes, items related to what’s fair and reasonable for recoverable direct costs, indirect costs defined by overhead-profit percentage, and impact factors resulting in consequential costs make up the majority of the disagreements. Direct costs are more easily justified and often included in change order requests. However, a lack of general acceptance, inexperience, and poorly defined standards for these — as well as indirect costs and consequential costs — plague many projects.
What’s needed is a standardized change order process and a set of standards that all owners, architects, engineers, general contractors, and subcontractors can adopt for all construction contracts. Standardization will facilitate a fair and reasonable process for costing and pricing change orders. It will also promote open communication and drive efficiencies in estimating. Lastly, it can help ensure fair profitability and project success for all participants.
Progress in motion
A number of subcontractor associations have started promoting a set of change order standards to the construction industry that may help the submittal and approval process. In 2011 — after nearly three years of research and collaboration, members of the Toronto Trade Association Standard Practice Committee introduced a Change Order Protocol that outlines guiding principles and a standard format/definitions for costing and pricing change orders. The document was drafted by a task force made up of electrical, mechanical, and sheet metal contractors, along with engineers, general contractors, and owner representatives from more than a dozen of Canada’s construction industry trade association partners. The Change Order Protocol is available from the Greater Toronto Electrical Contractors Association.
The Electri International released a study in December 2014 entitled, “Change Order Guidelines for Electrical and Low-Voltage Contractors.” The research team included construction management faculty Matt Syal, Joseph Diffendal, and Daniel Duah from the School of Planning, Design and Construction at Michigan State University. Included in the report are guidelines and templates that provide a systematic, standardized, fair process for the pricing of change orders for electrical and low-voltage contractors. This study identified various cost categories and items, investigated overhead-profit practices, and identified various impact factors and methods used to calculate associated consequential costs. The full report and its companion Quick Reference Guide are available on the Electri International website.
Building on the valuable resources from Electri International and Toronto Trade Association Standard Practice Committee, what follows are key findings, tips, and suggestions for establishing a consistent, effective, and profitable change order management process. By using these updated standards, the subcontractor community has an opportunity to educate and gain acceptance with general contractors, engineers, and owners.
Improve change order approval and acceptance
As an industry, we must expand our level of understanding and general acceptance of what is reasonable and fair for handling change orders. This requires a sweeping cultural change enabled by broad participation and support by everyone involved in the construction process — from owners, architects, general contractors, electrical contractors, and other MEP partners. To help establish a common ground of understanding, here is a list of guiding principles outlined by Electri International:
• Changes in the scope of work may be inevitable; however, a greater effort to diminish the volume of contract changes on construction projects is strongly encouraged.
• When changes become necessary, change orders should have a 30-day maximum turnaround. Contractors should submit an appropriately prepared quotation within 15 days, and owners should approve/reject within 15 days.
• Change orders should be fairly and reasonably priced and payment of approved changes should conform to contract terms.
• Contractors are entitled to overhead and profit.
• Reasonable disclosure of costs is encouraged, while excessive requests can be counter-productive, cause delays, and give rise to additional costs.
• If it is necessary to issue a change directive in advance of approval pricing and all related approvals, this formal direction to proceed should not diminish the urgency to negotiate a final change order price.
• The parties should be proactive in resolving disputes, and every effort should be made to ensure that these disputes will not impact the balance of the project.
If specialty contractors will embrace these publications, create internal documents emulating the findings, and educate their staffs on the need to consistently apply and use the documents, everyone in the construction industry will benefit.
Determine true costs
Establishing a consistent, detailed, and logical methodology to classify and justify costs for recoverable direct costs, overhead/markup, and consequential costs is vital to gaining change order acceptance and for project success.
Direct costs are the easiest to identify and quantify because they’re tangible. They also often visibly impact project outcomes; therefore, they’re generally easier to justify in the event of changes or alterations. Typical direct costs include labor, materials, equipment, and expenses related to the change such as moving, adding, or upsizing conduit, wire, and supports. However, there are additional direct labor, material, and equipment costs that are often overlooked and therefore impact profitability. For example, beyond the hourly rate to install a change, have you accounted for the time or direct expenses it takes to analyze, discuss, estimate, manage, and present the changes to the owner or engineer? Have you accounted for additional drawings, CMP revisions, or cost analysis? Does the composite labor rate include safety meetings, clean up, and supervision, and does it guarantee the work in addition to the list of all employer burdens?
For detailing direct material and equipment costs, don’t forget to consider that materials may be purchased for a different price at a different time and could have separate delivery costs. Additionally, presenting a complete rental schedule with daily/monthly costs — along with general expenses that may be applicable — can go a long way to help justify rental costs. You don’t want to surprise the engineer or owner with costs they haven’t seen before. By clearly listing the details for each category, you can greatly improve the approval process.
Indirect costs: overhead and profit
Defining indirect costs and calculating overhead versus markup versus profit can present a challenge. The percentages for overhead and markup are often predefined in the contract documents and typically range between 5% to 10% for each. Thus, the problem is not simply with the definition but also agreeing to a percentage that properly recovers both overhead and profit.
It’s important to appreciate that profit and markup on cost are not the same — and that a generic 5% to 10% range is arbitrary in many cases, preventing contractors from recovering their true costs. Subcontractors need to fully understand what overhead, markup, and profit is/how each is calculated, and be prepared to defend their positions.
Overhead expenses are administrative expenses of a business that cannot be allocated to any specific project but are necessary for the business to operate. To calculate an appropriate overhead percentage, add up all of office personnel salaries and benefits, office utilities, office furniture and equipment, business licenses, legal fees, autos and insurance, dues and subscriptions, property taxes, etc., that aren’t directly attributable to running a project. Then, divide all of these expenses by the total annual sales for your company. This should give you the overhead percentage you would expect to apply to the total change request to recover your overhead.
Research from the Electri International study mentioned earlier shows an average electrical contractor’s overhead is actually 19.16%. Critical to fully recovering that overhead percent is to know that applying 19.16% to direct costs (most often called markup) is different than applying overhead to the total change order amount. To calculate overhead on direct costs only:
(Overhead % ÷ direct cost %) = markup %
For example, if overhead is 19% and the direct cost is 81% of the total cost, then the correct markup to recover overhead would be (0.19 ÷ 0.81) = 23.5%.
This is a significant difference — and one that will likely require coaching and education to the GC/CM community before subcontractors gain acceptance.
Profit is generally defined as the amount of money a company makes after accounting for all costs and expenses (including overhead). Let’s assume that a 5% profit has been agreed to in a contract for all change orders. In order to convert the 5% profit to an appropriate markup on costs, use the same calculation as noted for overhead.
(Profit % ÷ all costs w/ overhead %) or (0.05 ÷ 0.95) = 5.3%
By marking up the total by 5.3%, you will achieve a 5% profit. The bottom line is that using the all-too-common 10% for overhead and 5% for markup or 15% combined overhead and markup (or even a 10%/10% factor) is likely not covering the true costs of your change requests.
Consequential costs
The final piece in recovering your true costs is to understand and account for consequential costs. These are the costs incurred due to timing and scope changes, which may impact overall project costs or duration. These include things like stacking of trades, reassignment of manpower, dilution of supervision, site access interference, or impact of seasonal and weather conditions.
It’s important to include potential costs on the change order with proper documentation. The Electri-International published more than 15 types of consequential cost references cost guidelines in its latest report. Detailing and substantiating calculations are key to your success. (click here to see a PDF version of the Table).
While consequential costs are real and do impact profit, historically these have been an area of contention for change orders. Clearly documenting and substantiating these costs will help you reduce risk.
(Click here to see a PDF version of a sample Change Proposal)
Goldsmith is the electrical/ICT segment manager for Trimble MEP, Westminster, Colo. He has more than 35 years of experience in the construction industry working as a contractor/owner before moving into the software side of the business. He can be reached at [email protected].
