March 22, 2021 Construction Law 101

Not Your Typical Overhead Caution Sign

Kevin Lugo and Scott Gailbraith

Many have seen signage cautioning them of overhead hazards on construction sites, warning equipment operators to avoid overhead power lines, alerting construction workers to not hit their head on low structural beams, etc. Owners and contractors should also be cautious of another potential overhead issue: overhead costs included in requests for additional compensation for extra work or time, or both, on a construction project. 

Customarily, an overhead expense is defined as “a cost or expense inherent in performing an operation, (e.g., engineering, construction, operating, or manufacturing) which cannot be charged to or identified with a part of the work, product or asset and, therefore, must be allocated on some arbitrary base believed to be equitable, or handled as a business expense independent of the volume of production.”

A contractor’s overhead costs are typically described as home office and field, or project, overhead costs. When preparing project bid estimates, and then when capturing actual costs during project execution for job cost accounting, change order preparation, and time related impact analyses, contractors typically account for each of these overhead costs as distinct line items added after accounting for the labor, materials, equipment, and subcontract expenses required to construct the project.

A contractor’s home office overhead is the expenses it incurs in the operation of its business that are not distinctly applicable to any one project. Generally, these include office rent or ownership costs, labor expenses such as management and support staff, and other costs for general business operations. Contractors customarily capture historical home office overhead costs as a percentage of the total direct cost of all projects, or as a percentage of the total revenue of all projects. When preparing bids, contractors typically budget anticipated home office overhead expenses by allocating a portion of these costs as a percentage of the estimated direct cost amount for the project.

Field overhead expenses are the contractor’s project level indirect costs not directly attributable to completion of a specific task, such as the installation of a masonry wall. Field overhead expenses applicable to a specific project are customarily allocated across all discrete direct work activities necessary to construct the project. Field office overhead expenses include the contractor’s indirect costs to support the work and do not include the specific material, labor, and equipment directly associated with the work. Typical field overhead costs may include field administration staff, supervision, quality control personnel, safety personnel, mobilization/demobilization, office trailers, temporary utilities, project-specific insurance, permits, taxes, etc.

Construction projects are dynamic and thus change is bound to occur resulting in unanticipated costs for both the owner and contractor. The contractor’s proposed additional costs will, or should, include its anticipated cost of the additional work plus its field and home office overhead expenses as components of the cost of a change in the scope of work. The contractor’s overhead expenses may be negotiated with the owner, contractually defined (typically as a percentage of the cost of work), or provided by the contractor in the change order price proposal.

Some contracts include a maximum overhead percentage that a contractor can add to the direct cost of the asserted changed work included in the change order proposal. This percentage may be specific to home office or field overhead or may cover all overhead costs. A key point to consider is how the contractor is capturing overhead costs and how it is allocating those costs during the project. If the contractor’s sole basis is a percentage, then consider that the contractor’s presumed overhead percentages at the time of bid may be much different than the percentage of home office or field overhead during execution of the contract and should be considered during negotiations for changes in the work. For example, if the owner believes a contractor had much more work during the performance of the contract than anticipated at the time of bid, then the owner may also require the contractor provide actual costs and revenue records beyond those for the specific project to support its home office overhead percentage applied to change order requests.

During a project, contractors submit change proposals, which the owner then approves, negotiates, or rejects. Oftentimes, the contractor and owner mutually and equitably negotiate changes in the work. Especially challenging projects may result in multiple change order proposals, change order requests, change orders, requests for equitable adjustments, and claims. In these instances, the cumulative overhead costs included in change proposals submitted may include field and home office overhead costs that are significantly more than can be reasonably demonstrated to have been incurred and recoverable under the specific contract. If not closely monitored, contractors run the risk of submitting proposals, and owners the risk of overpaying the contractor, for overhead costs not reasonably incurred due to project changes. Proposed overhead costs for the same time periods can become duplicative resulting in rejected change order proposals or protracted negotiations.

During negotiations for changes in the cost of work, the parties will either apply contractual overhead percentages or negotiate reasonable home office and field overhead percentages or costs supportable by the project record to date. This may require review of the contractor’s actual costs and revenue records to support its home and field office overhead. As is often the situation in change negotiations or disputes, the completeness and accuracy of the contractor’s bid assumptions and contemporaneous project records may well determine its ability to recover the proposed amount of additional overhead costs. Conversely, a contractor with a poorly maintained, or presented, project record will find it much more difficult to support its request(s) and potentially fail to recover reasonable additional overhead costs.

In the instance of contractor proposed time related overhead costs, it is prudent for the parties to consider the recovery of home office and field overhead in previously approved change orders and credit this recovery in subsequent change proposals, requests for equitable adjustment, and claims.

For example, a contractor submits a time-related change order proposal requesting a 10-day time extension due to additional work and $5,000 per day field overhead costs based on actual costs during the delay period, plus 10% home office overhead. The owner agrees the contractor is due a 10-day time extension but at no cost because of previous overhead recovery through change orders. In this circumstance, the parties will need to determine if the contractor has already been equitably compensated for the additional home office and field overhead costs recovered through previous change orders.

When negotiating change proposals based on a purported actual overhead percentage, the parties must understand that the actual overhead percentage will be impacted by any negotiated change to the originally proposed cost of the work.

We recommend contractors and owners seek input from outside consultants and counsel when handling requests for additional overhead compensation, particularly prior to submitting any form of a total cost or modified total cost claim. Guidance from experienced outside counsel and consultants can provide a third-party perspective to assist in making sure the asserted additional overhead costs for which recovery is being sought are not duplicative of overhead costs included in previously approved changed orders, including those which may have been rejected, or are associated with original contract work.

Those involved in managing construction projects should be mindful that on a project not all overhead hazards have warning signs and are clearly marked.

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Kevin M. Lugo, PE, CCM

MBP, Raleigh, NC

Scott A. “Gator” Galbraith, PE, CCM

MBP, Raleigh, NC