It’s no mystery to any MEP or other specialty trade contractor that submitting change orders for acceptance and prompt payment can be a significant challenge, negatively impacting your profitably on a project. Is it just a natural part of doing business in the construction trades, a necessary evil?
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 set of standards is not a magic bullet, it does offer a consistent and logical way to support change requests.
By using these updated standards, the subcontractor community has an opportunity to educate and gain buy-in from general contractors, engineers and owners. Let’s take a closer look at the proposed standards and how they can help maintain margin for your next project:
Identifying & Defining Costs
The three areas addressed in the new standards are:
- Recoverable Direct Costs
- Overhead / Markup
- 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 for the GC/CM, and therefore the easiest to get them to approve. All costs that can be directly attributed to the change request need to be clearly documented in detail, including all material, labor, labor burdens, equipment and other related direct job expenses required to complete the change. Clear and detailed documentation for each category will greatly speed up the approval process and improve your chances of getting the green light.
Overhead / Markup
The bigger challenge comes with agreeing on the definition and calculation of overhead vs. markup vs. profit along with the actual percentages. While everyone understands that businesses need to make more than they spend, that basic truth becomes harder to accept when you’re suggesting your own pay increase by means of a change order.
The percentages for overhead and markup are typically pre-defined in the contract documents and range between 5% -10% for each, so half the battle is making sure those pre-determined figures will adequately recover these costs in the event of a change order. Keep in mind that “profit” and “markup on cost” are not the same: there is a significant difference between how these two figures are calculated and how they impact the bottom line.
All subcontractors need to fully understand what these terms mean, how they are calculated, and how to best defend their inclusion in change order approvals.
Understanding Overhead, Markup & Profit
- Overhead is generally defined as all of the costs required to run your office, that can’t readily be charged 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 over 19%.
It is important to note that applying overhead to direct costs is different than applying overhead to the total change order amount. It’s always going to be in your best interests to apply overhead to the total change order since this provides a more accurate rendering of your real outlay while maintaining the profit margin the customer has already agreed to. Applying overhead just to direct costs leaves you paying for the privilege of making the change.
This is common sense, but it can make a significant difference in the change order quote. So, it 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 for overhead, then the profit percentage 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 5% profit has been agreed to in a contract for all change orders.
- The next calculation will be to convert the 5% 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.
- That means your actual profit figure will be slightly higher than 5% in order for you to maintain the 5% profit margin they’ve agreed to.
The key point is that an often seen 10% overhead and 5% markup, or 15% combined overhead and markup, are likely not covering the true costs of your change requests, which is where they become problematic.
The final piece of the puzzle when 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 - a change request requires you to place additional manpower within a limited physical space, which results in congestion and difficulty accessing material and tools, and therefore inefficiencies and greater cost.
- The weather factor - the change request requires your technicians to work in very hot or cold conditions, lessening productivity and, again, raising costs.
There are more than fifteen types of consequential costs referenced in numerous construction trade studies. While they are certainly 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 the subject showing that these costs may not be recoverable unless there is a breach in the contract, so the client has precedent for questioning consequential costs.
Still, it can’t hurt to identify these costs and be prepared to discuss them and submit where appropriate.
Moving forward we will continue to see the subcontractor associations working together to educate and work with the GC/CM community to establish a set of standards for the change order process.