The Basics of Change Orders and Change Order Management

Change orders can range from simplistic to intricate, can cause disruption or resequencing, and can eat away at profits.  In its most basic form, a change order is a contractor’s right to additional time and/or compensation for work performed outside the scope of the original contract.  Under optimal scenarios, change order pricing is negotiated prior to commencement of the change. However, given the fast-paced nature of construction, it is more common that change orders will be unpriced while work is being performed. Consequently, it is paramount that contractors have an understanding of how to account for change orders and how to properly manage the change order process.

The most basic category of change orders are owner acknowledged changes.  Simply put, these are changes that are initiated or approved by the project owner.  These types of change orders are the most desirable for a contractor since the likelihood of payment on this type of change is probable.  Under accounting standards, the contractor can include the full price of approved change orders in the contract price, assuming the realization and collection on the change orders is probable.

More complex categories of change orders include constructive change orders and consequential change orders.  These are changes that are not likely to be approved by an owner from the onset and are likely to be unpriced while work is being performed. The contractor will need to consider the probability of realization when accounting for the uncertain nature of these of changes.  Key factors to consider when determining probability include historical results of favorable negotiations, the customer involved and their financial stability, the type of work, and the economic environment.

Assuming the recovery of costs incurred on an unpriced change order is not probable, the contractor should charge the costs in the period they were incurred, with no corresponding increase to contract price.  If it is probable that the costs of an unpriced change order will be recovered, the contractor has two accounting options:

• In the first scenario, the contractor can elect to defer the costs incurred on the unpriced change order; that is, the costs incurred should be capitalized and included on the balance sheet. Once the change order price has been negotiated, the contractor adjusts estimated contract revenue by the negotiated price and charges deferred costs against cost of sales.
• In the second scenario, the contractor increases the estimated contract price by the cost of the unpriced change order, resulting in a zero gross profit change order. Upon final negotiation of the change order, the contractor adjusts the contract price to reflect the negotiated change order price.

If a contractor determines that it is probable that an unpriced change order will be priced out in excess of the cost, and assuming the excess can be reasonably estimated, the contractor can adjust the contract price by an amount equal to the anticipated change order price. This approach should only be used when it can be concluded beyond a reasonable doubt that the excess amount is recoverable.

In addition to sound accounting policies for change orders, establishing policies and procedures to manage change orders as walked through below will improve the likelihood of collecting on the change orders.

• The first step in managing change orders is to have a comprehensive understanding of your contract and plans. Additional work may be performed without any realization from an owner that it stemmed from a design error or a conflicting item in the contract.
• The next step in managing change orders is to establish an effective change order file.  This file could include date the change was discovered, emails, minutes from owners/project meetings, photos, plans and specifications, as well as change notice letters provided to the owner.
• Pricing out the change order is the next step in the process.  The change order can be priced out under time and materials for the obvious direct and indirect costs, with indirect costs generally including home office overhead and profit.  In regards to consequential costs, these are more difficult to calculate and include on the change order since the cost of these items are not obvious.  There are various methods to price the consequential costs, such as forensic estimating, delay analysis, measured mile calculations and various inefficiency calculations, all of which can include a multitude of complexities.

As noted previously, it is optimal that change orders be priced prior to the commencement of work.  Once the contractor begins working, the costs on the change will need to be meticulously tracked.  While all costs are important to track, indirect costs and consequential costs are more important to track since they tend to rely on calculations as opposed to the hard numbers seen in direct costs.

Change orders are dynamic and can have significant complexities involved, both from a financial reporting standpoint and a management standpoint.  With effective change order accounting policies, the contractor’s financial statements will have a higher degree of accuracy and will be viewed as reliable.  Additionally, with proper change order management policies, the contractor will improve its ability to be appropriately compensated for the extra work performed outside the scope of their original contract.

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