The ability to manage change orders effectively has a direct impact on your project’s profitability. Establishing a consistent, detailed, and logical methodology to classify and justify costs for recoverable direct costs, overhead/markup, and consequential costs are vital to gaining change order acceptance and for project success.
Determine True Costs: 3 Types of Change Order Costs
The majority of disagreements in the change order process are – with no surprise – due to cost. The top cost-related disputes are:
- 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
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.
1. Direct Costs
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. However, there are additional direct labor, material, and equipment costs that are often overlooked and therefore impact profitability.
Beyond the hourly rate to install a change there are many other expenses to take into account, including:
- The time or direct expenses it takes to analyze, discuss, estimate, manage, and present the changes to the owner or engineer
- Additional drawings, CMP revisions, or cost analysis
- The composite labor rate safety meetings, clean up, and supervision, and
- If it guarantees 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.
2. 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.
- 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 an Electri International study 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.
3. 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.
Consequential costs 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. Detailing and substantiating calculations are key to your success.
A Profitable Future for the Industry
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.