Evaluation of Risk in Change Orders

1. Evaluation of Risk in Change Orders Dr. Robert A Perkins, PE CE 620 6 November 2008

2. Outline • Intro to some risks in construction • Risks in change orders • Risk analysis basics • Applied to an estimate – quantitative • Estimating issues - qualitative • Risk in change orders – pricing • Markup – Risks and Uncertainty • Schedule Risks

3. Risks and Change Orders • Ideally transferred to the contractor • Forward price • Lump sum change order • Risk of early freeze up • Who bears risk • Extra protection? • Slowed work progress? • Loss of season and second year mobilization?

4. Risk and Cost • What’s it worth?

5. Owner Recognizes Change • Within Scope? • Unit prices • Not really a change • Negotiate Forward Price • Firm budget and schedule for PM • T&M • Unilateral Change • AK DOT

6. Risks to Owner • Asymmetric negotiations • Windfall • Can still have further changes • Differing site conditions • Impacts and Indirect Impacts (more later) • Contractor may not agree to certain risks • (more later) • T&M issues

7. Direct Risks to Contractor • T&M • Few, see next • Forward Price • Risk of underestimating • Costs • Schedule • Both

8. Indirect Risks to Contractor • Loss of bonding • Dilution of attention and supervision • Loss of float and flexibility • Alaska • Barge dates • Overwinter

9. Owner does not Recognize • Does not respond • NO

10. Risks to Owner • Constructive Change • No control over price • If confident, contractor has no incentive to be efficient • Smudge boundaries between original scope and change • Claim

11. Risks to Contactor • May not win claim • Cost of attorneys and staff • Loss of capital and bonding

12. Risk • Must start with basic estimate for work • Will vary with estimating method used

13. From Staircase

14. We are tempted to look at the point estimate and consider it the “right number,” • Then judge that the beta and 50% confidence level are closest to being correct. • But of course the point estimate itself is unlikely to be exactly correct. • My point here is that the difference between the 50% confidence number and the 90% confidence number is $1500; • the 90% confidence number is 15% greater than the 50% confidence number.

15. Which to use? • Owners and A/E’s might feel 50% confidence is “fair” • Contractors could not stay in business if they only made a profit 50% of the time

16. Schedule Risk • Similar Process • Easy to input Beta = PERT • Computational issues • Can lay critical path into Excel and use Crystal Ball or other • Schedule ties to duration of tasks and thus to item estimates and job estimates.

17. Pricing

18. Estimating Changes • Who generates? • PM • Job Engineer • Superintendent • Estimator • Subs • Who approves? • Authority? • Policy: sub, rentals,

19. Costing 101 • Job costs • Would not exist, if this particular job was not done • Non-job costs • Home Office Overhead • Profit • How about? • Winter pay of superintendents • Home office equipment shop

20. Profit 101 • All the market will bear? • Fair and reasonable? • Competitive? • Buyer’s market • Seller’s market • Return on Investment • Sunk costs • Garage sale price

21. But, Risk and Good Will • Good will • “Going concerns” worth more than their components • Often much more • Risk • Profit must allow for risks • Risky businesses must have higher RoR • Construction?

22. Variation of Cost Components • Labor • High risk of variation • Chiefly duration • Remote “deals”, 7-10s • Tight labor market issues • Installed Equipment • Low Risk for Contractor • Insured • May not cover delays • Higher risk for Owner

23. Operating Equipment • Vertical – low risk • Horizontal – higher risk • Operating Labor • Varies • Blue book • Ownership Costs • Operating vs. Standby

24. Operating Costs • Vary with conditions • Mechanic • Small tools and consumables • Generally varies with labor • But accounting issues

25. Other • Housing costs • Vary with duration • Special crews • Camp maxed out • Transportation for Remote • Bonding, two issues • May be direct to CO • Indirect via loss of capacity

26. Job overhead • Varies with duration • Second shift • Dilution of staff and supervision • Engineers • QC

27. Cost 102, Unit Price • Envelope, 25% or such • But allocations are not fixed in concrete • Heavy up units that occur early in job • Or sometimes, that the contractor believes will increase • “Unbalanced” usually means “unreasonable”

28. More • Each activity has fixed and variable costs • Averaged into unit price • Fixed costs include • Mob, Start up, and Demob • Learning curve – ramp up • What if activity in interrupted

29. Schedule Costs • Bonding • Retainage Interest • CPM and Crashing • Loss of Float • Contractor has no incentive to show any float in submitted schedule

30. HOOH • Allocation to HOOH vs. job • Must be consistent • For accounting it doesn’t matter • For CO it does • Eichlay • Careful, only really applies to total shutdown where contractor can’t work elsewhere • Non-allowable • Interest • Entertainment • For very large CO, much of the HOOH should be allocated to the CO.

31. Profit • Labor and “burden.” That is, costs that are attached to salary, such as fringe benefits, taxes, some insurance. • Equipment and purchased materials incorporated into the job • Operating Equipment, which consist of ownership costs and operating costs • Subcontractors. • Expendable materials and small tools (typically less than $500 in purchase), this may be a percentage of category A, labor.

33. Bay Area contractor survey • Some used 10% of total • May take 10% - 12% of total to be markup • That is HOOH plus profit • No allowance for risk • This was a stress time, 1990-1991, for these contractors

34. From Corps • HOOH is separate • Total would be 13% to 22% • Next looks at these and some SE heavy construction and others • Try to see how much is “risk”

37. Note the low end of the markups that include risk, but at the lowest risk values, are 17% and 13%; while the average of the T&M markup that also do not include risk are 14%, 14.5% and 21.6%. • The markups for competitively bid work, which includes risk, are somewhere between 10% and 12%. • The profit percentage is about double in negotiated and T&M work, compared to bid work. Huh?

38. Pricing Changes • Unit price within limits • Unit price over limits • T&M or Force Account • Contract or Gold book method • FARs

39. Types • Directed Change, only argue about money • Constructive change • Owner directs but feels it is included in the original contract • Cardinal Change, essentially breach by the owner • Owner mandates work outside the scope • Owner directs multiple or drastic changes so work is materially different. • Cumulative and Impact • Usually claim

40. Direct (Foreseeable) Impacts • AKA near impacts • Here is a list of typical direct impacts – generally proximate to the changed work in time and location. • Lack of work space. Overlapping trades. Work area congestion • Sequencing and buffer times. One trade or activity must precede others.

41. Demands on small pool of skilled labor. Tendency for remote work to stretch existing crews rather than mobilize new crews. Needing skilled workers at the same time on the changed and unchanged work. • Work on change forces interruptions of original work, learning curve • Out of sequence work • Lack of camp space • Decrease of manhour productivity with extended overtime

42. Shortage of mechanics and maintenance facilities • Increased supervision and engineering time, dilution of staff. • Dilution of line/field supervisors working on changed and unchanged work being done at the same time. • New planning and replanning, meetings • Learning curve, QC issues on novel work or situations

43. “A cumulative impact of change orders occurs when “the issuance of an unreasonable number [or unusual kind] of change orders creates a synergistic disruptive impact such that the total disruption caused by the changes exceed the sum of the disruptive impacts caused by the individual changes when looked at independently.”

44. Five elements are necessary to provide sufficient burden of proof for a cumulative impact claim • A significantly large number of change or disruptive events • The changes or events have an impact on productivity (performance time and efficiency) • The impact flow from the synergy of the number and scope of changes; • The contractor was unable at the time of pricing of each change or event or directive to foresee the ripple-type effect of the multiplicity of change and events; and • The contractor did not knowingly waive the right to assert cumulative impact claims when negotiating changes

45. Foreseeability • “This change represents full and complete compensation for all direct costs and time required to perform the work set forth herein, plus the overhead and profit as provided for in the Change clause in this contract. The contractor hereby reserves the right to submit a request for equitable adjustment for all costs resulting form the impact of this change on unchanged contract work. “

46. Fair and Reasonable Markup • (Perkins opinion – not on the final) • The risks should be evaluated and they are part of the “cost” of the change. I would use 90% confidence level of fairly estimated costs. • Uncertainties should be compensated in markup

47. Markup • So markup will include HOOH, which is auditable • Profit, which is auditable, and • Contingency for uncertainties

48. Unknown Unknowns • How to evaluate

49. Job factors that are likely to increase the risk of indirect or cumulative impacts.