If you are in the “construction world” you have probably heard about “change orders.” Change orders authorize contractors to receive compensation for performing additional work due to unforeseen issues on projects or changes in scope directed by the customer. Almost all construction contractors have to deal with change orders at some point in their normal course of business and are a necessary part of the construction process. While contract change orders have the potential to help contractors improve their initially estimated gross margin, it is not always the case.
Many Contractors are “Working-at-Risk”
Have you heard of the term “Working-at-Risk”? This term is used to refer to the many contractors that have no choice but to perform work on unapproved change orders before negotiations are settled due to specific deadlines. In many cases contractors are verbally told by their customers to go ahead with the additional work. This can be very risky for a contractor incurring cost on the contract because there is no guarantee that the contractors will receive any form of compensation for the additional work being performed. All cost going into these potential change orders are considered a sunk cost until there is some reasonable probability that the change order will be properly authorized or has an appropriate approval.
Customers do not want to pay extra and expect their contractors to perform the additional work for free.
Let’s face it, all customers love free service or products and contractors’ customers are not an exception to the rule. Very often, they are unwilling to pay excessive amounts for work required by a contractor’s change order so they include conditions in the terms of the contract to minimize changes to specific profit margins on documented costs. In other words, the contractor might be limited to a 5-15% gross margin on all allowed costs incurred for the change order. This can be a major factor in contracts when construction starts before the design of the project is complete and the contract is expected to have numerous change orders.
- With the economy constantly changing, profitability of construction contracts has changed as well.
- Contractors have been bidding projects more aggressively which tend to lead to lower profit margins, if any profit at all and are expecting to use change orders to make up for the low margins.
- Timeliness of notices can cause delays and loss in productivity, which can lead to a contractor not being fully compensated for work performed.
Change orders may in essence cause delays on projects, which can lead to issues with contracts that have hard deadlines.
In most cases, contractors should do what is best for their company and mitigate their risk on these transactions. Here are some tips on mitigating risks:
- Always get a signed change order by a person designated to approve or authorize change orders. In a variety of cases some sort of written correspondence may be sufficient. Do not fall for the “he said she said” method; it is not an official approval and is the number one cause of not getting paid on change orders.
- Be careful of including potential work covered by the scope of the contract in change orders which may lead to rejected values or changes. Consideration of the responsibility for each party involved with the contract must be a factor when submitting potential change orders.
- Be prompt with notice of potential changes. One significant item often missed is providing the customer prompt notice of cost associated with changes in the scope of contract. Timeliness of these notices can cause delays and loss in productivity which can lead to a contractor not being fully compensated for work performed. Keep your customers aware of all potential issues, timing could be everything.
- Detail potential delays in the change order submittal so they are properly documented. Change orders may in essence cause delays in projects, which can lead to issues with contracts with hard deadlines. Consideration of timing and extensions should be a factor when discussing terms with the customer. Having a realistic schedule is a key factor; being overly optimistic can cause issues later in the project.
- Formalize strong contract documents that place the majority of risk on the customer for unforeseen issues.
Mitigating risk on contract change orders can be very complex and delicate on your own. If you have a situation where change orders might be an issue, contact Lanigan Ryan for tailored advice.
About the Author:
Ryan Barnoski is a partner of the firm. Ryan’s main focus is in the construction industry where he performs audits, reviews, and compilations. He also provides business income tax planning and preparation, accounting consulting and advisory services. Ryan received his Bachelor of Science Degree in Accounting and Information Systems from Virginia Polytechnic Institute and State University in 2006 and is a licensed CPA in Maryland. He is a member of the American Institute of Certified Public Accountants and the Maryland Association of Certified Public Accountants. He is also a member and active participant in the Networking and Involvement Committee of the Associated Builders and Contractors Virginia Chapter.