Current Issues to Watch For in Construction Claims, Part III: Overhead ClaimsW. John Irwin II
July 7, 2008 — 1,369 views
Introduction: Overhead as a Cost Claim
The “Current Issues to Watch For in Construction Claims” articles in the March and April 2005 issues of Construction Update discussed impacts known as cumulative impact, cardinal change and abandonment, and damage issues related to total cost recovery and proof of delay with scheduling analysis. One particularly difficult area of damages is the calculation of extra cost claims for project site overhead and home office overhead. There are many disputes between the Contractor and the Owner over the dollar amounts claimed for overhead. Owners, construction managers and contactors must be aware of the different methods of computing claims for overhead costs. This article discusses several of these methods and their pros and cons.
What is Project Site Overhead?
Contractor project costs are usually grouped either as “direct costs” or “indirect costs.” Direct costs include labor, material and equipment installed as part of the work, and construction tools and equipment, all of which are charged to specific construction tasks. Indirect costs are those that cannot be identified with a specific construction activity but support the project as a whole, as, for example, costs of the project site management staff and the site office. Indirect costs are usually called “site or project overhead.” They are also called “general conditions,” since the site management usually performs tasks required by the general conditions of the contract. Some indirect costs are one-time costs, e.g. setting up the job trailer, and others are time-related, e.g. the monthly rental cost for the job trailer or salaries for the project site management.
What is Home Office Overhead?
Home office overhead represents the costs of the activities of the Contractor’s home, or corporate, office necessary to run the business and to support the projects in the field. These overhead activities include management, accounting, sales and marketing, rent, utilities, insurance, and so forth. Usually, the Contractor’s accounting system does not distribute these costs directly to specific projects. For example, an accounting clerk may work on several projects during a day but on the time card enters all 8 hours on one line item called “accounting.” It is also difficult to distribute home office costs to specific jobs. How does the salesperson distribute time to different active projects when his or her efforts do not support any ongoing projects? Therefore, home office overhead costs are usually posted to accounts that are not project related, and lumped together, they are called the home office overhead “pool”. The question remains: What portion of the home office overhead pool is used to support a specific job? The pool may be apportioned or allocated among the various jobs using some basis, e.g. based on the percent of total revenue contributed by each project or on the percent of total labor used by each project.
Claims for Extra Overhead Costs
Contractors are particularly sensitive if a project uses more site overhead or more home office overhead than originally bid, planned, or otherwise expected. Where the Contractor believes that the Owner is responsible for causing these extra costs, the Contractor may make a claim for such. Overhead claims may arise from delay attributable to the Owner, since many overhead costs are time-related. When delay arises from changes in work scope, overhead claims are usually referred to as “extended overhead.” When delay claims arise and the work scope has not changed, the related overhead claims are usually referred to as “unabsorbed overhead.” Overhead claims may also arise from acceleration, which requires the Contractor to add extra overhead staff. They may arise from suspensions, either full or partial, and from terminations for convenience of the Owner, which cause the Contractor to demobilize and perhaps remobilize the overhead staff and activities. They may arise from impacts caused by differing site conditions, by defective plans and specifications, or by the number or the magnitude of changes in scope. In one successful claim, for example, the Owner paid the Contractor for the second superintendent added to the site staff just to review the plans and specifications that were fraught with errors and omissions.
Overhead Claims Calculated by Contractual Markup
The question still remains: How to calculate the amount of the overhead claim? The Owner and the Contractor must consider carefully the contract clauses on requests for equitable adjustments. Typically the Change Order Clause of the contract allows for recovery of both site and home office overhead by means of a percentage of the direct costs. For example, the contract may allow the contractor a 15% markup on direct costs of the change to compensate the contractor for extra site and home office overhead. (The markup may also be designated as inclusive of profit, or profit may be a separate markup percentage.)
The language of the contract may even specify what costs the overhead markup includes. For example, one contractor lost a separate claim for home office overhead costs when confronted with the contract clause that the change order markup covered all home office costs as well as site overhead costs. The changes clause markup might only be for home office overhead, in which case, the contractor must present the site overhead costs as part of the direct costs of the change order or claim. Cost adjustment clauses may also include markups allowed on subcontractor change orders, which the Contractor should, or may be required by its contract with the Owner, to include in the subcontract agreements.
Overhead claims calculated by contractual markup are particularly problematic when the actual overhead costs of the related delay are much greater than the overhead costs recovered by the markup on the direct costs of the change. For example, suppose that the change direct costs are $10,000, and the overhead markup is 10%, or $1,000, but the Contractor has been critically delayed for thirty days at an actual cost of $500 per day for site and home office overhead. The Contractor’s actual overhead costs total $15,000, but the overhead compensation is only $1,000. Some claims have been successfully denied by Owners who argued that contractually the Contractor is only due the markup for any and all related overhead costs. On the other hand, some Contractors have approached this issue by filing a separate change order proposal or claim for the time-related overhead costs.
Overhead Claims Calculated by Estimated, Actual, Historical, Industry Standard, or Expert Methods
As an alternative to the markup method, the Contractor may calculate the overhead costs using some other methods. Overhead costs can be prepared as a “forward pricing” estimate and included in the change order or claim cost proposal. For example, the Contractor estimates 3 months of critical delay and prepares a cost estimate for three months of site overhead. It is more difficult to do this for home office overhead, since those costs are not easily related to specific jobs.
The Contractor may also make an overhead claim based on actual costs incurred. Again, this is relatively easy for site overhead. However, determining the actual costs of home office overhead is difficult unless specific home office personnel or resources are assigned to the project related task that generates the extra activity.
Finally, the Contractor can use historical overhead costs either from its financial records or from industry standards. For example, the Contractor’s annual financial statements show that over the past 5 years the home office overhead has averaged 12% of direct and indirect project costs, and the 12% is used as a markup on the direct and indirect costs of the change or claim to calculate home office overhead costs. Since site overhead varies widely from project to project, an historical average of site overhead may not be applicable to a particular project. Furthermore, the historical method may not be necessary for calculating site overhead, since these costs are readily available as they are usually posted to the specific job. In lieu of these methods, the Contractor may appeal to “industry standards” of overhead costs on similar projects or present expert opinion. However, these should be used only as a last resort, since the Owner will question the credibility and applicability of the selected standard or expert opinion.
Home Office Overhead Claims Calculated by Daily Rates
The above methods for calculating overhead cost damages raise the issue of how to apportion the home office overhead costs to a particular project, especially in the cases of suspensions and delays. “Daily rate” for home office overhead is one method used in the construction industry to simplify the calculation of extra home office overhead costs. This is akin to the “daily rate” method used by Owners in Liquidated Damage Clauses for Contractor-caused delay. To avoid arguments between Owner and Contractor, daily rates for home office overhead can be set contractually. On one public work project, the bid form included a line item of 50 days of project delay, for which the contractor had to enter a daily amount for home office overhead and the total of 50 times the daily rate. This locked in an agreement between the Owner and Contractor on the daily rate for extra home office overhead to be used in any compensable delay or suspension claim.
Another daily rate method, which is used in the Federal courts, is the Eichleay method. This was first promulgated in a case known as Eichleay Corporation, heard before the Federal Board of Contract Appeals in the late 1950’s. The Eichleay method or formula prorates the home office (HO) overhead pool based on revenue or billings. The Eichleay formula is:
1. (Project Revenue) / (Total Company Revenue For Contract Period) = % Project Revenue of Total Revenue
2. (% Project Revenue of Total Revenue) X (Total Home Office Overhead For Contract Period) = HO Overhead Allocated to the Project
3. (HO Overhead Allocated to the Project) / Contract Time = Daily Rate of HO Overhead on Project
4. (Daily Rate of HO Overhead) X (Calander Days of Delay And Suspension)
= Extended or Unabsorbed HO Overhead on the Project
(A) "Contract Time" used above is the number of calender days including original time plus time extensions plus delay and suspension.
(B) "Contract Period" refers to the time span from project start to completion, including all periods of granted time extensions, and claimed delay and suspension.
Contractors on Federal projects have tended to automatically use the Eichleay Formula to calculate home office overhead damages without proving that there was a government caused impact to home office overhead costs. In response, the Federal Courts have enforced strict requirements that the Contractor demonstrate: (1) that the delay or suspension was excusable and compensable; (2) that planned revenue on a project actually decreased during the delay or suspension; (3) that the home office overhead rates actually increased during the delay or suspension; (4) that the government required the Contractor to be on “standby,” readily available to resume work on short notice, (5) that the Contractor, undertaking reasonable efforts, was unable to obtain additional work to mitigate the increase in its home office overhead rate (proving that certain home office resources were effectively idled during the delay or suspension and “unabsorbed” by other revenue producing projects), and (6) that the Eichleay calculation is offset by home office overhead included in other changes and claims. Contractors must sustain all these proofs to make an effective and credible “Eichleay claim.” Having learned of the Federal Eichleay formula in all sorts of “delay claims seminars,” Contractors who try to apply Eichleay in claims on non-Federal public works and on private contracts may be questioned by State courts, by arbitrators or by private Owners in settlement negotiations.
Beware of Costs Included in Overhead Claims
Lastly, Owner and Contractor should examine what costs are included in overhead claims. Are the costs reasonable and allowable? To be recoverable, overhead costs must be reasonable and incurred in the normal course of managing a construction project or a contracting business. The Federal government will audit the Contractor and deny overhead costs that are specious or specifically excluded by the Federal Acquisition Regulations (FAR’s). For example, the audit of a Contractor making a claim against the U.S. Postal Service rejected the Contractor’s recreational vehicle as an unacceptable business overhead expense. On another claim, a school district audit rejected the Contractor’s bonuses paid at the end of the fiscal year, since they were a distribution of profit and not a home office overhead cost. Bad debts, contributions, entertainment, fines, losses, advertising and other specific costs are excluded by the FAR’s from the recoverable home office overhead pool. Also, one-time costs should be excluded from the “daily rate” calculations, since daily rates should only include time-related, continuing costs. One-time overhead costs attributable to the claim should be claimed separately from time-related overhead costs.
Summary on Overhead Claims
In the preparation of the Contract Documents, the Owner should carefully construct contract clauses on recovery of overhead costs by the Contractor. The Contractor should determine with its accounting staff and consultants the appropriate methods to account for overhead and to allocate overhead costs to specific projects. This must include discussion of what costs are reasonable and allowable in overhead. Overall, the Contractor must be consistent in its accounting practices for site and home office overheads. With respect to overhead claims related to delays and suspensions, the Contractor must maintain credible baseline, updated and impacted schedules in order to thoroughly document and prove that the delays or suspensions are excusable and compensable.
W. John Irwin II, PE, has an independent practice as a Mechanical Engineer and Construction Consultant, located in Valencia, CA. He has over 30 years experience in design, construction, construction management and construction claims/forensics. He specializes in forensic consulting and expert witness assignments in construction claims and disputes and in building mechanical systems. His clients include attorneys, owners, contractors, designers, and insurance companies. He teaches in the Construction Management program at California State University-Dominguez Hills and is a frequent speaker at Lorman seminars on construction topics. He can be reached at [email protected]