Who Should Pay for Pricing Scope Changes?

When a project owner has issued directives involving a changed scope of work, or is merely considering changes, the owner quite appropriately looks to the contractor for a price proposal. On a large, complex project, or a project plagued by excessive changes, the preparation of change order proposals can be quite burdensome for the contractor.

The common wisdom is that the cost of preparing change order proposals and negotiating contract modifications is part of the contractor’s general and administrative, or home office, overhead. This cost is absorbed by the mark-up on direct costs. But what if the proposal does not result in a change order? What if the project owner reduces rather than expands the scope of work? There would then be no increased direct costs to mark up.

In federal construction contracting, this problem is addressed by allowing recovery of the expense of proposing and negotiating change orders as a direct cost of project administration. The rationale is that the project owner, the government, controls changes in the scope of work and initiates the preparation of change order proposals. The process exists for the convenience of the government and the efforts should be compensable to the contractor.

Contractor recovery of change order proposal costs is strictly limited. The efforts cannot involve the prosecution of a claim against the government. The costs, such as attorney, accountant and consultant fees, must be segregated and allocated to that one contract. As one contractor recently learned, the costs cannot be carried in the G & A pool and then duplicated as direct contract costs.

As always, I welcome your comments on this matter.  Does it make sense to compensate contractors for the direct cost of a change order process which is controlled and initiated by project owners? Or, do contractors generally make out just fine with change orders and the mark-ups on direct costs?Bruce

Jervis, Editor

Construction Claims Advisor

Comments

[Bradley]

My opinion would be no. the should NOT be compemsated.

Change order amounts generally are higher than bid work which gives the contrator additional compensation. Also, proposal work is always part of teh cost of doing business and therefore part of the OH&P mark-up.

Charging directly would be double dipping in my opinion.

[J. Baker]

I think this has to be answered 'it depends'. If the CO/Proposal requests are limited and seem appropriate (to deal with an unforseen condition) then I would hope the project team would simply work through it.

If the number of requests becomes excessive and burdensome then there might be some bona fide cause for compensation. Maybe if the % of total contract price of CO's exceeds 20% of contract amount??

Of course if the owner is taking on this 'added (admin cost) risk' then I would hope the contractor would pass on some reward. Maybe less markup on approved CO's? I know as an engineer I charge for construction work on an hourly basis because I do not control the schedule/amount of work I do. Conversely, any savings from not needing my expertise is automatically passed on because I do not log time on the job.

[Chris]

I think that this should be addressed in the contract and an there should be some provisions for this...Alsom it depends on whether the contract is a lump sum contract or reimbursable.

I had a Lump Sum contract where we had 450 RFI's and over 60 change order requests, where only two change orders were approved...The Owner took advantage of the project team to price up many different scenarios, etc...

We presented a claim for additional overhead...We calculated the the time, cost and effort to process on RFI was over $500 and a change order was over $1,500...This included management and admin time,document production, time for review and Q&A, etc. We settled for a happy medium, but it was acknolwledged by all parties, that there was, indeed, a cost associated with both RFI's and CO's...

[Charlie Little]

If it's negotiated up front fine.
The contractor act's as an advocate for the customer on price,execution and the quality of the work.
In this market you do what it takes but you also let the customer know there are limits. The cause and effect of constant changes compounds to the third power. In the custom home business when you call for contractor pricing,the often heard "what do they want now" is followed by over pricing change orders. If you set expectations with the customer and politely explain that up front it's seems to do the job in most cases. If it doesn't it's part of doing business.
Charlie Little
Fairhaven Homes

[Mark]

Prior to reading my response, please note that my assumption of the contract being discussed is based on firm-fixed pricing. Other contract types, such cost-plus incentive, would completely change my reply since the cost impacts for changes are generally shared at a predetermined rate.

So... for firm-fixed price contracts . . . each proposal should always contain General Conditions, regardless of the project's size or complexity. Such conditions include the contractor's project management, contract administration, etc. This is the section of the proposal that should cover the costs for Change Management. Therefore, regardless of the cost impact (+ or -), there should be no additional line-item cost administer changes on a project.

[Alan Clancy]

Having been a contractor for more than 35 years, every owner thanks they are due a free estimate. Having constructed projects from a few hundred thousand to fourty million dollars, the burden of preparing estimates for owner's is something that is not carried under normal job overhead. Every estimate takes away from the contractors efficency to construct the job, costing him time,and money that is the contractors, not the owners. The owner has only paid for the work that is clearly shown on the plans and clearly spelled out in the specifications. Extra work, and clarifications causing changes in the scope of the contract are added costs and the contractors overhead normally paid on change orders only covers the contractors cost of doing business , not free estimates. There should be an established cost of estimate preparation fee on every change order and paid to the contractor even if the change order is not accomplished.

[howard i. littman, aia]

It always interests me that in discussing entitlements of contractors to payment for effort expended, a 'different' theory is used... that is, one that varies from our expectations of any other business or profession.

Let's turn the question around. Suppose an attorney has drafted and completed a complicated construction contract, and billed for his time. The client then says 'well maybe I'd like to see some different language in a particular section, so let me see a half dozen draft options for consideration'. The attorney prepares the draft options, but the client then decides to stick with the original language after all. Would the attorney NOT charge for the time to prepare the alternates for review, simply because the original contract has not changed, and the client has already paid for that work? Of course not.

On construction projects, every potential change order requires time and attention. It requires 'real time' to research and prepare the price and backup materials. The pricing is usually need ASAP. The effort diverts the attention of key project management personnel (i.e. engineer, PM, admininstrator) from their usual duties, and has flow-down impacts on the already-in-progress work. Similar impacts accrue to the subs who are mid-stream in their own work, and have managers and superintendents already working long hours to keep up. Then there is the attendant paperwork, the telephone conversations with designers and the owner, the meetings in which the PCO's must be hashed out, the 'highway robbery' conversations and inevitable re-pricing or tweaking effort, beating up on subs, etc. A large number of potential change orders can delay the entire project, and grow so burdensome that a contractor must actually bring on additional personnel (or shift work to home office personnel) just to do 'new' estimating, mentally working out possible physical integration issues with ongoing work, figure out sequencing and schedule impacts, and so on.

Complicating the issue is the type of contract. If it's cost-plus with a fixed mark-up, the contractor cannot 'adjust' his markups or otherwise recoup extraordinary time for unusually complicated analyses, if needed. And if the effort ultimately does not result in an increase in costs, or if it reduces costs, then the contractor has 'lost' the value of all the time expended... and possibly taken a 'hit' on his overall project fee to boot (depending on how the contract is written).

Regarding the comment, above, regarding change order pricing being higher than 'original' pricing, that can be true, but does not necessarily mean the pricing brings more money to the contractor as a 'rule', or is unfair. The higher pricing reflects a lesser purchasing power, premiums paid for expediting, premiums passed to subs for required escalation or overtime, and other factors that do not necessarily mean the contractor will garner more profit. Where the contract is cost-plus the contractor's mark-up and profit are not enhanced in any case, as they are subject to audit.

Other parties involved with consideration of potential change orders are usually compensated on an hourly basis... for example the architects/engineers that have to study implications of the proposed changes, research the products, prepare new design documents, process same for approval of the local jurisdiction, and then monitor the implementation of the changed work.

So why should anyone assume that a contractor should 'volunteer' its time? This is an issue that becomes a sore spot on most large projects simply because it is an issue not well thought out and not well-covered in most standard construction contracts. And when there are large numbers of PCO's, diverting attention of the contractor and subs, ultimately resulting in project delays, there is almost always also a 'fight' regarding whether those delays are legitimate or not. The process of chasing entitlements to the extra time and/or delays spent in developing potential cost and impact analyses, by itself, becomes burdensome and costly to the contractor - and those efforts are often 'required' to be during the job, not after, further impacting the ongoing work.

To be fair to all, this subject should be thoroughly discussed and negotiated at the onset of contract development - on par with other key time/money provisions. I do not think there is anything disingenuous or improper about a contractor's valid costs being incorporated as a fully-entitled component of proposed changes. If nothing else, when the Owner and designers understand that the contractor must be compensated for the impacts associated with analyzing and processing proposed change orders, this may keep them down to those that are truly essential/warranted, and eliminate frivolous ones.

[L.A. Edwards]

For minor/relative few change order events the standard admin. overhead and profit should cover the situation. But, if you have a runaway train and nothing in the contract to address the time involved in preparation of change orders - positive or negative, it will need to be addressed. If not done formally, the contractor will compensate in his pricing structure. Even if a change order results in a negative value, the contractor in his preparation of the negative number will have a positive number to cover the cost of the work to perform the take-off.

[Stephen Gerard]

Most owners have Division 1 specifications that include what is expected from the contractors bidding their work. Most often on public works projects, estimating services are established as part of the allowable markup on the submitted change. This language is as much a part of the contract as any other information provided in the documents, and the contractor has acknowledged that language when they submit a bid on the project. If the contractors General conditions did not anticipate costs for estimating, and/or they did not feel the allowed markup on changes would not be enough to cover their costs, then who is at fault?

There may be some lenience to this requirement if excessive changes are processed, the most difficult to answer is at what point does this occur, and what amount of that is already being paid for in the allowed markups?

I have personally had my time compensated for processing changes for contractors on government jobs (this was my business for 7 years), and now I review and negotiate contractor changes as a subcontract to a government body for the last 7 years. I have been on both sides of the fence. What I would say is that if the governing body has allowed a reasonable markup on changes, and is known to be fair in settlement, contractors will continue to line up to bid their work knowing full well the rules they play by.

[Andre Larroque AIA, CSI, NCARB]

Most standard contracts on public work don't specifically compensate the contractor for putting together change order proposals beyond what they can add for overhead by contract if the change is accepted. If a change order results in a reduction in contract cost the contractor should be able to keep the corresponding O&P amount contained in the original contract proportional to the change amount. This would cover some or all of his time responding to a request for a deductive change order. As someone has mentioned, contractors don't usually complain too much about having the opportunity to increase their contract amount after they have a contract and are free from the restraints of real competition. If the proposal is rejected, there is usually another one in the offing on the same job. An owner who significantly adds to the scope of work via change order probably doesn't mind paying champagne prices for beer.

[Bruce Jervis, Editor, Construction Claims Advisor]

I was interested in the several comments stating that the cost of change order proposal preparation should be addressed in the contract. Surprisingly, it rarely is addressed in public or private construction contracts. I like the suggestion that it become comepensable once the requested change orders cumulatively exceed a stipulated percentage of the fixed contract price.

[Darya Duma]

As a contractor, and even more so as a subcontractor, we have to keep good relations with our clients. In Canada, it is a small world, word of mouth is powerful. I hate nitpicking over changes, I feel strongly about forming a team with the customer at the start of the job and both focusing on what is best for the job. But at the same time, one has to protect the bottom line. I like the idea of specifically stating in the contract that a certain amount of estimating costs of change orders are covered, but beyond that the cost of estimating changes will be xxx. I have always kept that in the back of my mind, but have never specifically said so in a contract. I've been lucky and only been caught by pesky customers twice. Here's a thought: Stating that if a change is accepted the cost of preparing the estimate will be credited against the price of the change.

[Bruce P. Ogden, Esq.]

In a fixed price contract lacking a provision thereon (as most do), it maybe depends on the quantity and reason(s) for the CO requests. A few are to be expected and hence includable in the price. Massive amounts typically result from design errors, for which the owner is responsible to the contractor (per Spearin). Also, the owner who requests many just to consider the options arguably is committing a cardinal change, freeing the contractor from its fixed price as to that.

[Doug Collins]

I have never seen this defined in a contract and will often depend on the relationship and the original contract intent.
when contractors are pursuing 'repeat customers' a judgement needs to be made. if the job was acquired through low bid methods, then send in a change order to price the change order and see how it plays. Otherwise you need to get creative on the ones they accept.
I agree with most that it needs to be defined in the contract but isn't.

[tom frisby]

Are you aware of any court cases allowing the contractor to recover proposal preparation costs when it is not followed by a change orderl. And when the requests have become excessive and burdensome.