Dealing with change orders is an unavoidable part of running a construction business. Although often disruptive, they can actually be golden opportunities to increase project revenue. Unfortunately, many contractors lose money on change orders because they struggle to fully capture and charge all related costs. Let’s look at some savvy ways to make sure that doesn’t happen to you.

Cost classifications

You’ve probably experienced some of the common triggers for change orders. They include unforeseen site conditions, inaccurate or unclear specifications, owner-requested scope or design changes, unseasonable weather or other acts of nature, and materials shortages. Some costs associated with such changes are fairly obvious, but others are less so. To accurately price change orders, you generally need to consider three cost classifications.

First, there are direct costs. These include labor, materials and equipment, of course. But they can extend beyond the costs of the change-order work. For example, direct costs may also include staff time spent analyzing the changes, preparing estimates, and communicating with the owner or engineer. You could incur professional fees for redesign work. Or you might have to put in additional hours for supervision, safety meetings and cleanup. There’s the cost of fuel, utilities and storage to consider as well.

The second classification is overhead. Unless you recover these costs as well, you could end up losing money on a change order. Overhead for construction businesses is generally divided into two subsets: 1) general and administrative, and 2) project (often referred to as “indirect costs”). As with many types of companies, general and administrative overhead includes rent, office equipment and utilities, and management and administrative staff salaries and benefits.

Project overhead/indirect costs relate to work being performed but can’t be tied to any one job. Common examples include workers’ compensation insurance premiums and payroll service fees. More specific examples vary depending on your company’s size and specialty. Ask your accounting professional for help identifying yours.

The third classification is consequential costs. Change orders can disrupt workflow, creating a ripple effect felt throughout a project. These consequential costs may include those associated with work delays, overtime, crew reassignment, site access issues and weather conditions. They could also include the cost of lost productivity resulting from, for instance, trade stacking —the need for multiple tradespeople to work in a limited space. Problems often arise, too, from “dilution of supervision.” This is when the attention of project managers and on-site supervisors is diverted from planned work to change-order work.

Finer points

Ensuring adequate compensation for change-order work starts with the contract. Before signing, check any contractual limits on pricing change orders, such as maximum markup percentages.

Many contracts provide for a markup percentage of 10% to 15% for change orders, which is intended to cover overhead, indirect costs and profit. But it’s often not enough to break even. A thorough analysis of a significant number of recent projects should tell you whether your typical markup percentages are sufficient. If they’re not, try to negotiate higher limits.

In addition, train your project managers to familiarize themselves with each contract’s change-order approval procedures. Implement controls to ensure these procedures are followed to the letter. For example, you should generally avoid beginning out-of-scope work until a change order is approved in writing.

Once a change is approved, stay focused on costs. Track all three cost classifications closely. Consequential costs are usually the most difficult to prove, so be sure to have systems in place to measure and document productivity, compare results to the originally budgeted hours, and calculate the impact of change-order work on productivity.

Beneficial superpower

The ability to manage change orders effectively is a “superpower” that often differentiates best-in-class construction businesses from those struggling to consistently turn a profit. So, why not put on your cape and start tracking all project costs? Your accounting professional can help you refine your company’s job-costing method, markup structures and change-order procedures.

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