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Industry Insights

Change Orders, Part 2:
Negotiating Changes
By Giovanni Marcelli, Chairman and CEO

Last month, we looked at how estimating changes differs from estimating the base contract. This month, we examine the art of negotiating changes.

One approach that works very well is to set the rules of the game well before the real change notices start coming. As soon as the contract is signed, an experienced PM should meet with the authorized agent for the owner and agree on key parameters such as labor units, supervision percentage of craft labor, other labor charges like engineering, estimating, scheduling, as-built drawings revision, warranty, material costs, equipment rental, definition of overhead, and finally, the format of the submission.

I would also emphatically recommend that a cost-plus process be clearly addressed as an option to a lump-sum cost.

From the very beginning, impress upon the owner’s agent that you do not want any change orders; in fact, offer a credit if they refrain from issuing change notices. Impress upon him that to complete the project on time and on budget, you go through a rigorous and time consuming process of creating work drawings, order materials, and getting your team well acquainted with the project—in short, the Pre-Construction Planning process.

Well before the project starts, your team is ready for mass production. However, as soon as changes come, all the preparation and planning goes down the drain. As a result, productivity suffers and a lot of additional planning is required.

Mr. Owner, changes are very costly; please do us both a favor, do not issue any changes.

Contractors used to be able to get a markup of 10% for overhead and 10% for profit. Strangely, our time schedules for project completion have shrank, our overhead costs have increased, and often enough, we are only allowed 10% for both overhead and profit.

The 10% fee in most cases does not cover overhead, let alone profit, and when I talk about overhead, I define it as those expenses that a company must incur in order to retain a presence in business for the purpose of securing work. Any costs that are derived from a particular project must be viewed as direct job expenses. Project managers and job site clerical or engineering staff are not overhead, nor is the site office or equipment.

If we fail to clarify and agree up front on what constitutes overhead, we run the serious risk of having to provide many services for free.

It is not uncommon for an owner to take the position that the PM has to be on the job anyway and therefore should not be charged. The same argument could be made for non-craft workers, office trailers, storage trailers, equipment, tools, and whatever else is on the job.

Negotiating fair and reasonable parameters up front is mutually beneficial, will save lots of time later, and will minimize the chances for disputes and claims.

Your contract most likely contains a clause that gives the owner the unilateral right to make changes to the project. In this instance, failing to agree on a lump sum price for the change will trigger the force account approach, which means that you will be forced to do the work, keep track of costs and later, sometimes much later, you will be negotiating a cost resolution.

If the parameters of the cost resolution are not well defined, and if the PM is not well prepared for such an instance, most likely he will only recover a portion of the direct costs, and no impact or consequential costs.

It is very useful to know that a large amount of changes in a project can make the original contract null and void. In legal terms, this is called "cardinal change". The courts have recognized that when many changes are made to a project, the very nature of the project changes, and therefore the original contract needs to be changed as well. Some experts claim that the cardinal rule can be invoked once the total labor required for the changes reaches 25% of the original project, and sometimes less.

That being the case, we could renegotiate the 10% overhead and profit to a 10% overhead and 10% profit, or possibly more.

What do we charge for materials? The contract may indicate that the contractor shall charge materials at cost. Cost is usually not well defined. Should cost include the time and effort to order, receive, stock, inventory, bring to close proximity of installation, warranty for defective materials, contingency for lost or stolen material, risk for cost escalation, delivery or pick up?

In my opinion, these are all legitimate costs that should be included in the total cost of materials.

I have heard of some owners questioning why should they be charged extra for the PM on the change order when he is already on the job site? Others make the argument that the PM is covered by the overhead fee.

Let us get the facts straight: the PM is there to take care of the base contract. His job is to provide the information, materials, tools, and equipment at the right time at the right place to the field crews. His primary responsibility is to complete the job on time on budget by avoiding conflicts, motivating the field people, clarifying issues, keeping the crews productive, and looking after the company’s interests. The PM is busy enough doing that and does not need the headaches and disruption that changes bring about.

Often disputes arise over a lump sum price. If the electrical contractor cannot refuse to do the work, he should proceed on a cost-plus basis, bringing additional field crews and supervision to the job site. The changes should be treated as a separate job, and the cost-plus crews should be directed to minimize interference and loss of productivity on the base contract.

The base contract crews are usually your “A” team—well trained and well acquainted with the project, as you have already paid for their learning curve. Cost-plus should also afford you the flexibility to do the changes after hours or weekends when necessary in order to minimize conflicts with the base contract.

When doing cost-plus work, keep meticulously accurate records and progress invoice on a weekly basis. After all, you are entitled to charge for all costs incurred, including the clerical work required to document and track costs.

In next month’s article, we will address the importance of detailed documentation as a selling and negotiating tool for lump-sum change orders.