Construction delays chapter twelve home office overhead

Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead Construction delays chapter twelve home office overhead

Home Office Overhead

WHAT IS HOME OFFICE OVERHEAD?

In the event of an owner-caused delay, a contractor may seek to recover delay costs associated with home office overhead For many rea-sons, despite being a commonly sought element of delay costs, home office overhead remains a contentious issue The reasons given for opposi-tion to payment of home office overhead as a cost of delay are many, but most can be categorized as follows:

• Some do not agree that there is a home office overhead cost incurred

by the contractor as a result of a delay or that any cost incurred is the contractor’s risk and not the owner’s responsibility

• Some believe that the home office costs associated with a delay are fully compensated by the markup for overhead provided on the cost of the change that caused the delay or on the other delay costs being sought

• Some disagree with the formulas that are often used to calculate home office overhead costs

Adding to the potential for conflict is the question of what constitutes home office overhead, a term that can take on different meanings given the financial structure of the contractor’s organization and the accounting principles employed Commonly, however, home office overhead consists

of the contractor’s fixed costs of operating its principal or home office

It is in the home office that executive and administrative functions are performed on behalf of the contractor’s entire organization, including individual projects Examples of such costs are shown inFig 12.1

Specifically excluded from this definition of home office overhead are the direct costs of labor, equipment, and materials expended to construct and manage a specific project The cost of providing a job site trailer, e.g., is not a home office cost as it is incurred specifically to support a particular project

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The auditing or accounting standards employed by the owner can fur-ther restrict the definition of home office overhead For example, under contracts governed by Federal Acquisition Regulation (FAR) cost princi-ples, certain costs, such as those expended for marketing and entertain-ment may not be recoverable as home office overhead costs As a result,

on Federal projects, or on projects that rely on the FAR for the purposes

of cost accounting, these marketing and entertainment costs end up being covered by whatever amounts the contractor is able to mark up its costs for profit, if at all

Regardless of the exact nature of its home office overhead, a con-tractor must pay for these costs by drawing funds from the projects it performs There are many ways for a contractor to do this Many apportion home office costs to projects based on some appropriate measure For example, home office costs might be allocated to a proj-ect based on the projproj-ect’s revenues or billings Another contractor might apportion home office costs based on the contractor’s project labor costs

Figure 12.1 Example of home office costs.

Normally the contractor includes home office overhead costs as a part

of its pricing for each project For projects that require the contractor to prepare a lump sum bid price, the contractor often calculates the final bid price by adding a markup percentage to the direct costs in its bid to pro-vide for home office costs The exact markup depends on the contractor’s historical home office overhead costs, which the contractor typically eval-uates on a quarterly or an annual basis When reviewing a contractor’s bid documents, this markup is often identified as “G&A” for “General and Administrative” costs It might also be identified as “G&A&M,” where the “M” stands for marketing expenses

The number of projects the contractor has under construction at any one time may also affect the markup For instance, if a contractor works

on only one project at a time, 100% of the home office costs for the period of construction would have to be covered by the project As the number of projects increases, the percentage allocated to each job would

be reduced, as shown inFig 12.2

EFFECTS OF DELAYS ON HOME OFFICE COSTS

As just mentioned, a contractor typically includes in its bid price for a particular project a percentage markup through which it will recover some portion of its home office overhead If this project were to then experience a delay, project revenues may be earned over a longer period

of time, disrupting the basis under which the contractor originally allo-cated its home office overhead costs This effect can best be demonstrated through a series of examples

Figure 12.2 Percent of home office overhead costs absorbed by each project.

One project at a time

For the contractor who performs one project at a time, the effect of a delay

is relatively straightforward As shown in Example 12-1, the contractor did not receive additional compensation for extra work on change orders to off-set the increase in home office costs to be covered by this project If, how-ever, the 1-month delay was the result of extra work with direct costs of only $10,000, and the overhead markup allowed by the contract was 10%, the contractor would receive $1000 for overhead as compensation for the extra work This overhead markup would have to cover both field and home office overhead If actual home office overhead costs were $4000 per month, the contractor would be $3000 short in recovering home office costs and have nothing left to cover field overhead costs Of course, if the value of the change was $100,000, the 10% markup would be greater than the overhead costs incurred By their nature, markups are not intended to compensate the contractor for its actual overhead costs Sometimes compen-sation provided by markups will be higher and sometimes lower than the actual cost incurred The difference between delays caused by a suspension and those that result from extra work are addressed later in this chapter Example 12-1 A contractor has home office costs of $48,000 per year and has one, 1-year contract with a value of $1,000,000 The project experiences a 1-month delay during which time home office costs of

$4000 accrue (Many home office costs are roughly constant month to month If the contractor’s home office costs are $48,000 per year, then they are likely averaging approximately $4,000 per month.) If the delay were the result of a full suspension of project work and the delay was compensable, the contract amount of $1,000,000 would remain the same, but the contractor would now have to cover a total home office cost of

$52,000 over the term of the contract, an increase of $4000

Contract amount: $1,000,000

Yearly home office costs: $48,000

Unchanged contract amount: $1,000,000

New home office expense, including extending the project 1 month:

$52,000

Increase in home office costs to be covered by this project:

$52,000 48,0005 $4000

Based on this example, the contractor would seek $4000 to cover its home office costs for the delay

Multiple projects

As shown in Example 12-2, the contractor has multiple ongoing projects Clearly as the number of projects increases, the calculations become more difficult, as is apparent from the numerous books, legal briefs, articles, and web entries related to this subject In characterizing home office overhead costs, some choose to distinguish between the terms extended home office overhead and unabsorbed home office overhead The calculation of costs for each may differ, but in practice, courts and boards have not always main-tained a clear distinction between these terms This chapter will treat these costs as being essentially the same The remainder of this chapter presents methods for calculating delay costs associated with home office overhead Example 12-2 This contractor has home office overhead costs of

$1,000,000 per year The contractor normally has four projects in prog-ress at any one time, for a total yearly volume of $20,000,000 The con-tractor allocates home office costs by adding a 5% markup to each bid Each of the four projects is valued at $5,000,000 What would happen if one project were to experience a delay?

Originally each project absorbed $250,000 of home office costs, or about

$21,000 per month If one project experiences a 1-month delay due to a full suspension of work on the project, then the contractor would receive no additional revenue to cover home office costs from that project, and would therefore suffer a net loss in recovered or “absorbed” home office overhead costs of $21,000 If the delay were attributable to added work rather than a suspension, then the contractor might receive compensation from the over-head markup allowed on the change order However, in the absence of extra work, the project experiencing this delay may underabsorb its share of the home office costs, leaving the other projects to overabsorb these costs

EICHLEAY FORMULA

The difficulty in precisely establishing the home office overhead costs due to delay has led to the development of formulaic approaches to determining the appropriate compensation to be provided to reimburse a contractor for its unabsorbed or underabsorbed home office overhead

costs One such method is the Eichleay Formula The formula originated from a decision by the Armed Services Board of contract Appeals in 1960 (Eichleay Corporation, ASBCA 5183, 60-2 BCA 2688) In its appeal before the Board, the Eichleay Corporation proposed a formula for calcu-lating its costs for home office overhead during a delay The Board accepted this formula, which has since become known as the Eichleay Formula, as a reasonable method of calculating such costs

The Eichleay Formula is a simple three-step formula First, the total contract billings are divided by the total actual company billings for the contract period, as shown in Fig 12.3 The quotient is then multiplied

by the total home office overhead costs during the actual contract period

to produce the allocable overhead Next the allocable overhead is divided

by the actual number of days of contract performance, including the delay This produces the daily allocable overhead rate (Fig 12.4) Finally,

inFig 12.5, the daily allocable overhead rate is multiplied by the number

of days of compensable delay to produce the home office overhead costs

A short example illustrates the application of the formula A company has total billings of $50,000,000 during the contract period The contract billings total $5,000,000 Total home office overhead is $1,000,000 during the contract period The actual project duration and the contract period total 200 days, and compensable delays total 30 days The first calculation

to produce the allocable overhead of $100,000 (Fig 12.6) is as follows: The next calculation produces the daily allocable overhead rate (Fig 12.7) And, finally, in Fig 12.8, the daily allocable overhead rate is

Figure 12.3 Eichleay Formula: Allocable overhead calculation.

Figure 12.4 Eichleay Formula: Daily allocable overhead rate calculation.

Figure 12.5 Eichleay Formula: home office overhead damage calculation.

multiplied by the number of days of compensable delay to yield home office overhead costs of $15,000

Problems with the Eichleay Formula

While the Eichleay Formula is simple to apply, some have questioned its accuracy The Eichleay Formula is an estimated allocation and may, there-fore, yield results that are either too high or too low Despite this limita-tion, the Federal courts and Boards have, for the most part, accepted the formula as a reasonable approximation of the damages sustained With less case law to draw upon, state courts have been less receptive to outright acceptance of the formula

Debate over the use of the formula has led to refinements regarding its application For example, in Excavation-Construction, Inc., ENG BCA 3851 (1984), the Engineering Board of Contract Appeals (ENG BCA) recognized the use of the Eichleay Formula to determine the cost not only of a suspension of work but also of a delay caused by extra work The Board’s opinion is noted in the following quote The Board did, however, subtract from the Eichleay calculation the amount of over-head that was already being paid by virtue of the markup on the change order

Figure 12.7 Eichleay Example daily allocable overhead rate calculation.

Figure 12.8 Eichleay Example home office overhead damage calculation.

Figure 12.6 Eichleay Example allocable overhead calculation.

The Board believes in general that an Eichleay-type approach is the preferred way to determine home office overhead in a suspension situation and that a markup of direct costs is the preferred way to determine home office overhead for a change However, no automatic approach can be applied in avoidance of

a careful scrutiny of the facts In this appeal, the changed work on the retaining walls is only part of the reason for extension of the contract period Much of the delay and disruption occurred because the change was not timely made The parties have agreed that the net effect was to extend the period necessary for performance by 99 days Measurement of the effect on home office over-head by the costs alone is likely in these circumstances to understate the amount to which E-C is entitled Therefore, the Board considers this appeal to

be a proper one for application of the Eichleay Formula.

The Armed Services Board of Contract Appeals’ response in George

E Jensen Contractor, Inc., ASBCA No 29772 (1984), is as follows:

Finally, the Government argues that the home office or extended overhead costs are fixed costs which would have been incurred even if there had been no delay Its argument continues that to allow relief by utilizing the Eichleay Formula would permit recovery of overhead costs much greater than the direct costs incurred during the periods of delay This argument misses the point Home office expenses are indirect costs usually allocated to all of a contractor ’s con-tracts based upon each contractor ’s incurred direct costs When a government initiated delay causes a contractor ’s direct costs to decline greatly, that contract does not receive its fair share of the fixed home office expenses The Eichleay Formula is one method approved by boards and courts over a long period of time which corrects this distortion in the allocation of these indirect expenses.

The most common argument against the use of the Eichleay Formula

is that the contractor receives compensation for home office overhead by virtue of the markup on a change However, a criticism of this argument

is that a contractor likewise receives this same markup whether the change causes a delay or not

Unless the markup clearly contains an allocation for home office over-head, the argument that Eichleay should not be used may not be valid The following quote shows how the ASBCA addressed the point in Shirley Contracting Corporation, ASBCA No 29848 (1984):

We find no support for this position The Corps ’ Area Engineer testified that he did not know the composition of the 15 percent allowed but nonetheless approved it as a matter of course He also admitted that the 15 percent over-head was allowed even ‘on modifications that involved no delay at all.

Arguments against the broad application of Eichleay are provided in P.J Dick Inc., Appellant, v Anthony J Principi, Secretary of Veterans

Affairs, Appellee Nos 02 1290, 02 1401, April 07, 2003 The United States Court of Appeals decided in part, as follows:

In short, a court evaluating a contractor’s claim for Eichleay damages should ask the following questions: (1) was there a government-caused delay that was not concurrent with another delay caused by some other source; (2) did the con-tractor demonstrate that it incurred additional overhead (i.e., was the original time frame for completion extended or did the contractor satisfy the Interstate three-part test); (3) did the government CO issue a suspension or other order expressly putting the contractor on standby; (4) if not, can the contractor prove there was a delay of indefinite duration during which it could not bill substantial amounts of work on the contract and at the end of which it was required to be able to return to work on the contract at full speed and immediately; (5) can the government satisfy its burden of production showing that it was not imprac-tical for the contractor to take on replacement work (i.e., a new contract) and thereby mitigate its damages; and (6) if the government meets its burden of pro-duction, can the contractor satisfy its burden of persuasion that it was impracti-cal for it to obtain sufficient replacement work Only where the above exacting requirements can be satisfied will a contractor be entitled to Eichleay damages.

On the subject of suspension, the Court wrote:

Our case law clearly requires that the contractor must show a suspension, whether formal or functional, of all or most of the work on the contract.

Explaining this statement further, the Court added:

As to PJD ’s factual arguments, those too must fail The Board found that “[t]he evidence before us shows conclusively that PJD was able to progress other parts

of the work during the time periods it alleges it was suspended ” Although PJD argues the evidence shows its direct billings were greatly diminished during the delays, substantial evidence supports the Board’s finding The evidence, at worst, shows that in one of these delay periods PJD billed 53% less than it had the month before There is, however, no evidence whatsoever that PJD ’s direct bill-ings were less than they would have been absent the suspensions-that is the controlling test A comparison of pre- and intradelay billings or intra- and post-delay billings is not the test Regardless, PJD’s direct billings during the post-delay periods can hardly be characterized as “minor.” See Altmayer, 79 F.3d at 1134.

At worst, PJD ’s direct billings during one of the periods of suspension were 47%

of what they were in prior months; thus, PJD continued to perform substantial amounts of work on the contract during the suspension periods On these facts, which are supported by substantial evidence, we must affirm the Board’s con-clusion that PJD was not on standby.

Based on these examples, recovery of unabsorbed home office over-head costs using an Eichleay Formula is not automatic Like all claims for delay costs, to recover home office overhead costs, the contractor must

first establish that the delay was indeed compensable This typically entails establishing that the delay was on the critical path, delayed the project completion date, was the owner’s fault or responsibility, and could not have been reasonably anticipated or otherwise mitigated by the contrac-tor In addition, many courts that have accepted the Eichleay Formula have attached other prerequisites to its application These may include the contractor establishing (1) an owner-imposed suspension of all or nearly all of the work on the project, (2) an owner requirement that the contrac-tor be on standby during the associated delay, and (3) proof that while on standby, the contractor was unable to take on additional work

When to apply the Eichleay Formula

Based on the examples presented, it may be evident that the Eichleay Formula is a calculation applied at the end of the project after all of the delays have occurred and the work is completed If the parties attempt to resolve the question of home office overhead during the project, some form of a modified Eichleay Formula may be appropriate One approach

is to apply the Eichleay Formula from the beginning of the project up to the point of negotiations In this situation, the total contract billings, the total company billings, the total home office overhead costs, and the total number of days from the start of the project up to the approximate date

of the calculation may be used However, there has been reluctance on the part of the Federal Boards and courts to accept the use of a “modi-fied” Eichleay Formula But, by the time such disputes get to an actual trial, the project will have long been completed and there is no longer a need to use a modified formula

As noted earlier in this chapter, when using the Eichleay Formula in Federal government cases, because of the FAR, some costs (such as adver-tising, entertainment, interest, etc.) that might be included as home office overhead costs are not allowable The government will normally disallow these costs during its audit procedures In its contract, the Federal govern-ment has the right to audit a contractor’s records For delay claims in excess of $100,000, the government will often perform an audit

Other jurisdictions, such as at the state and municipal level may or may not allow recovery for unabsorbed home office overhead or may or may not allow the use of the Eichleay formula For example, New York State Courts have rejected the Eichleay formula and prefer, instead, a for-mula known as the Manshul forfor-mula In addition, many jurisdictions