Managing the True Cost of Change Orders

Change orders that are not proactively and properly managed account for unanticipated productivity and job profitability losses. This article explains how detecting and avoiding the side effects of change orders can help prevent these losses. It also explores why construction financial professionals (CFPs) must recognize that change orders, once official, only cover the portion that the customer has initiated.

Other hidden changes such as schedule changes, movement to other locations, and “favors” initiated by GCs produce extra work performed by the labor that is an invisible aspect of cost and labor overruns.

How to Prevent Derailing From the Original Schedule

In order to make the resource usage visible and prevent cost and labor overruns, the three elements of labor performance must be separated as follows:

  1. Work is what needs to be done to complete the project;
  2. Effort is the hours needed by the specific individual(s) who will perform the work; and
  3. Time is the duration over which the effort must be exhorted for the work to be completed.

Without a clear picture of work, effort, and time, other labor and material usage will be unpredictable, which in turn means that the project’s profitability will be unprojectable and unknown.

The project team in the field is doing far more work than what is being priced because the complete set of changes that the installers are addressing are not visible to the GC and owner. You should use the original project schedule as a yardstick to measure the impact of change orders and prevent it from derailing.

If the change order shows an impact on the original project schedule, then it should be noted and considered when pricing the change order. The new schedule should be based on the project’s original schedule, which matches the work that your team is contracted to complete.

Making Change Orders Visible & Trackable

A written work breakdown structure (WBS) translates the tacit knowledge and experience of field leadership into explicit knowledge, which then becomes the baseline used by field labor to recognize changes. To effectively maintain the project’s original schedule, contractors must immediately detect and react to changes when they occur — not after the costs are incurred and recognized in financial reports.

While the financial reporting eventually shows how much is lost to unrecognized changes, it is often too late for the project team to recover lost profits due to unplanned and unmanaged expenses. The WBS implements proven management methods and tools.

The quickest access to change order visibility occurs when labor is able to recognize changes prior to performing work. Second to that is the ability to detect reduced productivity on the work planned in the original WBS.

With efficient and streamlined original project plans, the field labor will not perform unplanned tasks because they will simultaneously affect the base work’s measurable productivity. If your productivity measurement tools are not detecting these changes, then they are not implemented within an effective process of project management. This could only mean that the tracking method is either not used by the field personnel or is not useful for them, which means it is more of an accounting tool than a field and project management tool.

Any project tracking and measurement tool based on American Society for Testing & Materials (ASTM) Standard E26911 will enable your team to quickly detect productivity changes resulting from unplanned work that occurs on the job, whether the changes were recognized and reported by the labor or not.

To effectively detect and mitigate any unresolved profitability losses, a process to measure productivity against the original budgeted hours in addition to all of the work associated with all base scope changes must be developed and implemented. Regardless of whether the changes are approved, they must be tracked to calculate the labor’s effectiveness and efficiency against the baseline scope of work.

Exhibit 1 shows that the productivity impact of the change can be seen as soon as the change to the work is reflected in the tracking tool. Therefore, the earlier it is recognized and entered, the earlier you will be able to see and quantify the impact of the change. This will also give your team more time to attempt correction and recovery.

Managing Extra Capital in the Change Order

In order to realize increased profitability from change orders, the change in planned profit must first be recognized. Then, without diminishing the profits of the current work, the associated change order’s work and money must be managed. This cannot be accomplished without visibility into a job’s performance.

The project is most vulnerable to a change order’s negative impacts when it is granted through a notice to proceed (whether verbal or written), a contract value revision, or when additional labor or materials are added to the project plan and WBS.

If you only pay attention to the money and labor involved and not to what is happening operationally, then the change order money is frequently used as a way to cover any shortfalls that already exist on the job, such as previous bidding and selling negotiations and/or variations from expected productivity.

To incorporate the added profitability of more expensive change orders in the end results, due to higher labor or material cost, the added profit to the change order must be removed from the revised cost. For instance, if the original job was bid with $70 an hour for the labor cost and the change order is bid at $75 an hour, the added $5 should come off the job’s profitability calculation and be added to the company’s profit.

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