Construction Change Orders: Process and Best Practices for Project Success

As mentioned above, the three cost types that construction change orders must take into account are direct (which is the easiest type to understand), indirect, and consequential (the latter two can be very difficult to quantify).

1. Direct Costs: These are the costs that are directly involved in implementing a change order. Some direct costs are obvious — materials, labor, and equipment. Others are not as apparent: professional fees for a redesign; fuel to run equipment; staff hours to coordinate a change and communicate it to engineers and site crew; fuel; security; project insurance; sales tax; permit fees; licenses; safety measures; cleanup; and utilities. Calculating certain direct costs in particular requires taking into account a wide variety of factors. Here are the methods for calculating various direct costs: 
   • Calculating the Cost of Construction Labor Components: Labor includes work hours and rates, labor supervision, and project supervision. This cost also includes benefits such as sick pay, insurance, and retirement, as well as employer taxes. 
   • Pricing Materials for Construction: To calculate the base cost of materials, use price quotations from vendors or actual costs. To this base cost, add the costs of transporting, storing, handling, and inspecting material.
   • Assigning Costs for Rented and Owned Construction Equipment: When determining change order-related equipment costs, many factors contribute to your calculations. Most significantly, do you rent or own your equipment?
     • Rented Equipment: In order to calculate the cost of rented equipment, first determine an hourly rate by multiplying the rental charge by the number of hours you need to perform the change order work. Then, add the operating costs, such as fuel and lubricant. 
     • Owned Equipment: If you own the equipment, specify your pricing method in the contract, unless you’ve already established your own equipment cost recovery rates for allocating equipment to a project. The recovery rate for such an allocation reflects the purchase price, sales tax, depreciation, cost of ownership (such as insurance and licensing, maintenance, overhauls, and repairs over a machine’s expected lifespan), and financing cost/opportunity cost.
       
       If you do not have an established recovery rate, you can calculate one by consulting the retail rental rates of such industry references as the AED Green Book, Rental Rate Blue Book, and Army Corps of Engineers Equipment Rates.
       
       To calculate a maximum hourly rate for the change order work, take the monthly rate and divide it by the 176 available working hours in a month. Typically, you must cap the rate at 50 percent of the machine’s market value at the time you first used it for a change order.
       
       If your situation is not complex enough to merit detailed calculations, a good rule of thumb is to price the equipment you own at 50 to 60 percent of the retail rental rate.
       
       Whether you rent or own your equipment, you need to add operating costs, including fuel and oil, parts, fluids, shop space, and storage. In addition, when you are calculating equipment costs in the context of change orders, you must apply different rates based on the status of the machine under consideration. In other words, your rate for a specific machine must reflect its level of wear and tear (i.e., is it on standby, idle, or active?). When you calculate the rate for standby equipment (i.e., available, on-site equipment that you are not currently running or using), that rate typically includes depreciation, cost of capital, overhead, and indirect costs. When you calculate the rate for idle equipment (meaning available, on-site equipment that you are currently running, but not using), that rate includes depreciation, cost of capital, overhead, indirect costs, labor and parts for scheduled overhaul, and fuel.
2. Indirect Costs: Indirect costs include overhead, profit, and markup. Although these costs are only indirectly related to change orders, you must account for them in your change order pricing.
   • Overhead: This refers to the administrative expenses that you incur running your overall business, but that are not allocable to any individual project. This category includes office rent, office equipment, office utilities, management and administrative staff salaries and benefits, advertising, taxes, training, business licenses, staff vehicle insurance, legal and accounting costs, association dues, and service or warranty work on current equipment and other structures.
     
     Typically, large companies have higher overhead costs than do smaller firms. To calculate your overhead percentage, divide your total company revenue by your total overhead costs:
     
     Total Annual Revenue $ ÷ Total Overhead $ = Overhead %
     
     (You usually spell out the profit and markup percentages in the construction contract.)
     
     But, many contractors lack a strong grasp of their indirect costs and, therefore, underprice them, experts say.
     
     For example, construction cost experts consider 10 percent to be a standard overhead cost. However, a study on change order-guidelines by ELECTRI International (The Foundation for Electrical Construction) found that electrical contractors spend an average of 19.16 percent to run their business.
     
     Using the conversion formula below, this 19.6 percent for general business overhead yields 23.7 percent for the overhead that directly concerns change order costs. This discrepancy between percentages occurs because you are calculating your overhead percentage for direct change order costs on the basis of total sales or revenues:
     
     Overhead % ÷ (1 - Overhead %) = % of Direct Change Order Costs
     
     Plug that 19.6 percent for general business overhead into the above formula, and you will yield that 23.7 percent for the overhead that directly concerns change order costs:
     
     0.1916 ÷ (1 - 0.1916) = 23.7% or 0.1916 ÷ 0.8084 = 23.7%
   • Profit: There are two types of profit to consider regarding indirect costs: net profit and gross profit.
     • Net Profit: This refers to the amount that the contractor makes after subtracting all costs and expenses, including overhead. The average net profit is five to 10 percent of all revenue.
     • Gross Profit: This refers to the amount that the contractor makes before subtracting all costs and expenses, including overhead.
     • Markup: This refers to the amount that the contractor adds to costs (both direct and overhead) to arrive at a profitable selling price. You must also factor the markup into change order prices. A common industry standard for markup is 15 percent. Much like the concept guiding the formula above (the one for calculating the overhead percentage of direct change order costs), the markup percentage must exceed the desired profit margin percentage in order to achieve that desired profit margin.
       
       For example, to achieve a 20 percent profit margin, you must mark up costs by 25 percent; then, you price the change order accordingly. The discrepancy between these two percentages exists because, while profit margin percentage increases at a linear rate, the correlating markup percentage increases at a rising rate.
       
       The competitive landscape and the economic climate both influence pricing. Therefore, the markup and profit margins that you apply to your bids should carry over to your change order pricing.
       
       For example, in a highly competitive market or during an economic downturn, a contractor may price their bid with a lower-than-standard profit margin. Similarly, when stiff competition and price transparency make owners resistant to higher markups on commodity items, a contractor may apply only a nominal markup to materials.
3. Consequential Costs: These are the indirect costs (specifically hard and soft expenses) that you incur as a result of a change order. These costs are “consequential” because they are the direct consequence (i.e., the ripple or cumulative effect) of the change order itself.
   
   Consequential costs include such factors as project delays, overtime, training, morale, crew reassignments, and inefficiency. These costs also include labor productivity losses from the stacking of trades (the phenomenon in which multiple subcontractors work in a limited space). In turn, trade stacking introduces safety hazards and other obstacles, including increased difficulty in accessing materials.
   
   Industry literature, surveys, court cases, and case studies provide guides for calculating the impact of such change order-related factors. Among these resources are the Mechanical Contractors Association of America’s Toronto Change Order Protocol and Andrew Civitello’s Contractor’s Guide to Change Orders.
   
   Hanna Consulting Group, Inc. and its President, Dr. Awad Hanna, Professor and Chair of the Construction Engineering and Management Program at the University of Wisconsin-Madison, developed a method called the Cumulative Impact Approach. The method determines the probability that a change order will impact an overall project. Hanna also invented the Measured Mile Approach, a method for quantifying the costs of such a change order impact on an overall project. In addition, the firm also worked on a method for quantifying the impact of trade stacking.
   
   The U.S. Army Corps of Engineers and various other industry entities have also developed methods for calculating consequential costs (i.e., the cost of each factor that has an impact on productivity).
   
   You estimate the cost of each of these factors based on their impact: minor, average, or severe. For example, a severe stacking of trades results in a 30 percent loss of productivity, while minor fatigue results in an eight percent reduction in productivity, according to ELECTRI International’s research.
   
   When you calculate consequential costs for a change order, be prepared to support your numbers with authoritative references. This way, if the change order becomes the subject of a dispute, you’ll be able to prove that your calculations were fair and reasonable.