Change orders are an inevitable part of the construction business. And that’s not necessarily a bad thing. When properly handled, a change order can mean more revenue coming your way and, if all goes well, a more profitable project.
On the other hand, without proper planning and an effective process for managing them, change orders can just as easily erase a job’s profits. It’s been said that you can’t manage what you can’t measure — and that’s certainly true of change orders. Unless you understand their true costs, it’s impossible to manage them and preserve your well-deserved payoff for the extra work completed.
3 types of costs
Possible reasons for change orders include unforeseen site conditions, inaccurate or unclear specifications, owner-requested scope or design changes, unseasonable weather or other acts of nature, and materials shortages.
Although certain costs associated with these changes are readily apparent, many others are less obvious. To accurately price change orders, you need to consider three types of costs:
1. Direct costs. These include labor, materials and equipment. They can go beyond the expenses involved in doing the actual change-order work. For example, the costs may also include staff time needed to analyze the changes, prepare estimates, and communicate 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.
2. Overhead and indirect costs. As you’re no doubt aware, direct costs are only one piece of the puzzle. Unless you recover your overhead, indirect costs and a reasonable profit, you could end up losing money on a change order.
Overhead for construction businesses is much like that for any company. It includes rent, office equipment and utilities, and management and administrative staff salaries and benefits, and other general business expenses.
Related to overhead, but distinctive nonetheless, are indirect costs. Generally, these are considered a cost identified with more than one job, such as workers’ compensation insurance, or a cost that’s only indirectly related to on-site activities, such as payroll service fees. Ask your CPA for help identifying other types of indirect costs.
Many contracts provide for a markup percentage for change orders, such as 10% or 15%, intended to cover overhead, indirect costs and profit. But this often isn’t enough for a contractor to break even on change-order work. One study, for example, reported that the average overhead percentage for electrical contractors was more than 19%.
3. 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,
- Crew reassignment,
- Site access issues and
- Weather conditions.
They could also include the cost of lost productivity resulting from things such as stacking of trades — that is, 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 the change-order work.
Mind the details
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. If they don’t sufficiently cover your costs plus a reasonable profit, try to negotiate higher limits.
In addition, familiarize yourself and your project manager with the contract’s change-order approval procedures. Put controls in place to ensure they’re followed to the letter. Generally, you should avoid beginning out-of-scope work until a change order is approved in writing.
Once a change is approved, stay focused on costs. That means tracking all three types of costs discussed above. Consequential costs are usually the most difficult to prove, so it’s critical to have systems in place to measure and document productivity, compare it to the originally budgeted hours, and calculate the impact of change work on productivity.
Protect the bottom line
No matter how profitable a job looks on paper, that margin can fade to zero without effective change-order policies and procedures. By understanding the true cost of change orders — and ensuring your construction company has processes in place to document and recover those costs — you can help protect the bottom line of each job and your business as a whole.
Should you ever work for free?
Generally, no contractor should ever work for free. After all, it’s not your fault if the plans and specifications fail to accurately reflect the owner’s current wishes. If the contract’s scope is revised, you should be compensated accordingly.
That said, the benefits of doing a moderate amount of free work can sometimes outweigh the costs. These advantages may include:
- Building goodwill with an owner who could offer you more work in the future,
- Avoiding conflict with an owner who has a reputation for litigiousness,
- Helping secure the quick release of retainage, and
- Improving the chances of completing the job on time and within budget.
If you conclude that the pluses of providing free change work outweigh the minuses, be sure to take credit for it. Many contractors document such work with a “no-cost change order.” Doing so not only allows you to track the additional costs involved, but also shows the owner how much additional value you’re providing.