While some change orders have a minimal effect on an original contract’s scope or value (or both), they cannot be overlooked. Cumulatively, or even individually, change orders have significant impacts on sequencing, budgets and resources. Because of this, work associated with change orders tends to be riskier than the original contract scope—especially pending or unsettled change orders—because the contractor is often required to proceed without formal approval from the owner or prime contractor. While pending change orders are often inevitable due to time constraints in the construction process, a contractor with effective accounting and recordkeeping protocols is well-positioned to provide indisputable documentation on the financial impacts of changes.

The key to success in proving and recovering on change orders is having the necessary policies and procedures in place prior to experiencing the changed condition (and in reality, prior to starting the project). Having these policies and procedures in place helps identify not only the costs of changes, but also their scope and often the fact that the items constitute changes in the first place. It is likewise critical for systems to reveal the elements and types of costs attributable to changes.

Identifying Costs
Direct costs related to changes are specifically attributable and usually straightforward with regard to identification and quantification in the accounting records. On the other hand, indirect costs associated with changes warrant careful consideration. One or more changes may result in the need for additional supervision and cause loss of productivity (the latter often referred to as cumulative impact), requiring acceleration and overtime to meet project deadlines, or requiring a time extension, resulting in extended general conditions and other indirect costs.

While acceleration and overtime appear to be easily identifiable as direct costs, the causes of the acceleration may have been the result of a change event that occurred months, or even years, earlier. This cause-and-effect relationship as a result of changes is one of the most contentious issues that arises during the negotiation and settlement of change orders with customers. As such, a contractor should maintain effective records, such as daily reports, as-planned schedules, time impact analyses, change-specific cost codes and allocations, meeting minutes and emails.

Tracking Costs
Once a policy is established to help identify costs, the contractor should ensure that its accounting system is appropriate and applicable to the construction industry. A proper accounting system has strong job costing functions, which are integral to capturing not only base contract costs, but also change order costs. The job cost module tracks expenditures applicable to each project, allowing managers to analyze reports comparing budgeted productivity to actual results and to identify early on the impacts and costs of individual and cumulative change orders. Effective reports provide managers with the necessary information to take corrective action for projects that do not appear to be meeting their anticipated profitability. This early identification of problems helps contractors recognize and address the ripple effects of changes.

Two key elements that help track and control costs are the committed cost and remote upload features. Under the committed cost feature, the contractor establishes budgets for each project component. Should invoices entered into the system exceed budgeted amounts, the system alerts the user and may require the user to adjust budgeted amounts. This early detection feature forces the user to acknowledge that the project is not progressing as planned and serves as a critical control over cost overruns, profitability impacts and the identification of potential changes.

With regard to remote uploads, technological advances allow for labor costs incurred in the field to be uploaded to the job cost module daily. Having real-time data enhances managers’ ability to identify potential problems that may be a result of compensable changes.

Effective accounting software also should possess change management modules that track the recognized date of the change, who initiated the change and the approval status of the change. Additionally, such software compares changes to budgets, revisions to production units, and calculates the cost of the changes. Assuming that the proper data and modules are available, the direct and indirect costs of the change can be determined through this system.

Monitoring the costs of change orders should be done in a manner that is consistent with capturing the costs associated with the base contract. An effective method is to establish separate cost codes for changes so that such costs can be identified easily. Consistent with accounting for the base contract, cost codes for changes should include labor, equipment, materials, subcontractors, overhead and profit, and should be assigned on a change-by-change basis. It is critical that field labor and supervisory forces accurately and contemporaneously use these cost codes to track base versus change order work.

While it requires effort to track in this manner, more data is then available to document the costs incurred, which allows the contractor to accurately bill the customer for work performed and to determine additional profit for the change. If a requested change is significant enough, the contractor can establish a separate project number for the change; generally, the project number in this case would have a suffix that is a unique identifier to change order work. This approach allows for project personnel to easily code incurred costs and improves the contractor’s positioning should there be a dispute on the change.

A contractor should aim to strike a balance in the level of detailed cost codes employed. Cost codes should not be so granular that inputting them is a major burden throughout the project. Further, there are risks to having multiple types of cost codes. For instance, if project personnel mistakenly code change order costs to base contract codes, it may be difficult to recover those costs during negotiations. The customer could question the costs that were coded incorrectly and argue that the coding was not done in a consistent and accurate manner, even calling into question costs that were properly coded. As such, how and when to use separate cost codes must be communicated to all project personnel.

Lawrence M. Prosen is an attorney and partner in Thompson Hine’s construction practice group. Christopher Vasquez is a senior manager in the Construction Industry Services Group at Aronson LLC. For more information, email lawrence.prosen@thompsonhine.com or cvasquez@aronsonllc.com.