Improving Change Order Approval and Acceptance
It is no mystery to any electrical, or other specialty, trade contractor that submitting change orders for acceptance and prompt payment can be a significant challenge and can negatively impact your profitability on a project. Recently, after publishing a report on change orders, a number of subcontractor associations have started promoting to the construction industry a set of change order standards that may help the submittal and approval process. While this is not a magic bullet set of standards, it does present a consistent and logical methodology to back up change requests. By using these updated standards, the subcontractor community has an opportunity to educate and gain acceptance with general contractors, engineers, and owners.
IDENTIFYING & DEFINING COSTS
The three areas addressed in the new standards are recoverable direct costs, overhead/markup and consequential costs. These areas are typical discussion points when the general contractor or construction manager (GC/CM) questions the cost of the change. Direct costs should be the easiest to define and gain agreement with the GC/CM. All costs that can be directly attributed to the change request need to be quantified and listed in detail, including all material, labor, labor burdens, equipment, and other related direct job expenses required to complete the change. By clearly listing the details for each category you can greatly improve the approval process.
The bigger challenge comes with agreeing on the definition and calculation of Overhead vs. Markup vs. Profit along with the actual percentages. The percentages for overhead and markup are typically pre-defined in the contract documents and range between 5-10 percent for each, therefore the problem is not simply with the definition but also agreeing to a percentage that properly recovers both overhead and profit. Keep in mind that profit and markup on cost are not the same, there is a significant difference between how markup and profit are calculated and how it impacts the bottom line. All subcontractors need to fully understand what is overhead, markup, and profit, how they are calculated and be prepared to defend their positions.
UNDERSTANDING OVERHEAD, MARKUP & PROFIT
Overhead is generally defined as all of the costs to run your office that are not readily chargeable to one project. You would calculate an appropriate overhead by adding up all of your 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 are not directly attributable to running a project. Then divide all of these expenses by the total annual sales for your company. This will give you the overhead percentage you would expect to apply to the total change request to recover your overhead. Research from electri-International, “Change Order Guidelines for Electrical and Low Voltage Contractors 2014,” shows an average Electrical contractor’s overhead is slightly more than 19 percent. It is important to note that applying overhead to direct costs is different than applying overhead to the total change order amount. If you are required to calculate overhead on direct costs only, the calculation would be (Overhead % / Direct Cost %) or (.19/.81) = 23.5%. A significant difference and one that will likely require coaching and education to the GC/CM community before subcontractors gain acceptance.
If the GC/CM agrees with you on the calculations on overhead then the profit percent should be an easier discussion. 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 five percent profit has been agreed to in a contract for all Change Orders. The next calculation will be to convert the five percent profit to an appropriate markup on costs. The calculation is similar to the overhead calculation assuming that we are applying the markup on all costs including overhead. The exact calculation would be (Profit % / All Costs w/Overhead %) or (.05/.95) = 5.3%. By marking up the total by 5.3 percent you will achieve a five percent profit. The key point is that an often seen 10 percent for overhead and 5 percent for markup or 15 percent combined overhead and markup or even a 10 percent/10 percent are likely not covering the true costs of your change requests.
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. This may be a bit more difficult to calculate as they include things like stacking of trades, where a change request requires you to place additional manpower within a limited physical space, resulting in congestion and difficulty accessing material and tools. Another example would be the weather factor where the change request requires your technicians to work in very hot or cold conditions. There are more than fifteen types of consequential costs referenced in numerous construction trade studies. While, consequential costs are real costs, this is a bit of a gray area when trying to get them approved by a GC/CM. There have been several court cases on this subject showing that these costs may not be recoverable unless there is a breach in the contract. Knowing this, you should still identify these costs and be prepared to discuss and submit where appropriate.
Paul Goldsmith is the Electrical/ICT Segment Manager for Trimble MEP, an IEC National Platinum Industry Partner. 35 years in the Construction Industry working as a contractor/owner moving in to the software side of the Construction business. For the last 20 years, Paul has been dedicated to the Electrical/ICT Industry, working with many Electrical companies helping them increase their productivity and proﬁtability. Paul has been married for 32 years with two adult children–one of which left the fold to join the Mechanical side of the house while the other helps companies hold onto their money.