The Consequences of Poor Change Order Practices

In a good economy, just about anyone can make money without good business practices.

However, to survive through a poor economy, it is necessary to have the discipline to develop and use best practices that improve the performance of jobs.

Some of the most effective operational best practices include:

Customer and Project Selection Processes

Do you have a process to pursue the best customers and opportunities for work or do you continue to work for customers that nickel and dime you on change orders and pursue work with low profitability?

Pre-Job Planning

Is each job planned so thoroughly before work begins that managers in the field understand how they will beat the budget and schedule before stepping onto the job, or do you actually believe that sending the crew out to start the job without a plan to be successful is the way to start a job?

Short Interval Planning

On projects with schedules exceeding two weeks, do foremen or superintendents document their plan for the next two weeks to demonstrate how they will remain on schedule and budget? Or do they show up for work without a plan to be successful that day?

Daily Crew Huddles

Do foremen meet with their crews first thing every morning to address safety, production and the best way of getting the job done today or is the plan just to work hard?

Change Order Management

Does your company have a documented change order policy and train managers in its implementation or is everyone expected to use their best judgment in this area?

Project Closeout

Do your managers in the field hold a closeout meeting at 90 percent complete to establish the plan and accountability to finish the job in a timely manner or do the seem to be unable to finish work and get off the job?

Post Job Reviews

Does the entire team, from foremen and project manager to safety, estimating and accounting, meet at the end of every significant project to determine what went well and what could have been performed better? Otherwise, do your personnel simply move on to the next job without the understanding of what could be done better to improve performance throughout the entire organization?

In all the companies I have observed the last several years that were in financial trouble, poor change order practices were a significant reason for their condition at least 25 percent of the time.

Although minor in terms of revenue, change orders have a considerable impact on net income. The example below demonstrates the impact of not pursing change orders properly. Let us assume that you have in total $100,000 of change orders for which your customers would not pay. In other words, you incurred the cost and performed the work but did not have signed change orders. You performed the work but ultimately, customers refused to pay because the job is complete. You lost your leverage over your customers by performing the work then asking for payment after the fact. To make up for the $100,000 of lost change order revenue, let’s consider that you just need to pick up an additional $10 million more in new work if net income on your financial statement is currently 1 percent of revenue as in the example below.
 

Some owners of construction firms have confided that after seeing this example, they would have to double their annual revenues to make up for all the change orders lost in the previous year.

Now consider companies that manage change orders well. First, their change order practices are so well defined and understood that managers in the field know exactly what to do when a changed condition occurs. Second, their change order processes are consistently followed. Third, they do not record the revenue from the change order until it is signed by the customer.


The key elements to managing the change order process include the following:

Know your contract.

Without a good understanding of the contract from the project manager down to the foremen putting the work in place, change order conditions are unclear.

Do not concede your leverage by performing the work before getting a signed change order.

This is the most contentious issue with the subject of change orders. Often the language of the contract puts the contractor at a disadvantage, because they can be directed to complete the change order before the price is settled with the customer. Other contractors will pursue wording so that additional work cannot be performed without a signed change order.

Do not surprise the owner by waiting until the end of the job to submit your change orders.

Interestingly enough, some of the largest companies in the country do not have their change order practices well defined. Project managers wait until it is too close to the end of the project to address change orders.

Be persistent in pursuing the signing and collecting of change orders.

Customers may sign your change orders but hold off paying them until the end of the job. At that time they are used as negotiating points against you when it is time to collect retention. The result is that you performed work in good faith only to collect $.50 on the dollar to get your retention released. When change orders are billed, but remain unpaid, pursue their collection diligently.

Do not record change orders as revenue before they are signed.

There are too many instances observed where revenue is recorded before the change order is signed. Booking revenue in this manner has an impact on cash. Your income statement may ultimately deceive you because you will be profitable but have no cash.

When developing a change order, consider this list of costs that are frequently overlooked:
 

•     Additional time
•     Consumables
•     Small tools
•     Clean-up
•     As-built drawings
•     Bond
•     Project insurance
•     Material handling
•     Safety
•     Gas and oil
•     Warranty reserve
•     Cost of money

The items above should become part of the process that checks to make sure you have everything included in your change order. Ideally, it would be best to develop your own internal checklist as a means of assuring each change order is complete.

Another factor to consider is the impact on the productivity of your employees as they work more than forty hours a week. A number of studies have been performed in this area. Intuitively, it just makes sense that your people are less productive as they work more than forty hours a week. The degree of inefficiency is striking:

Part of the process to develop a change order should be to factor the efficiency of labor into the pricing as craft labor continues to work more than forty hours a week. Ultimately, the cost of monitoring safety will have to increase as well because the probability for accidents will increase in direct relation to how tired everyone has become.

When developing change order process itself, consider the following as an example:

• Step 1-Recognize changes in scope that include constructive changes, acceleration of the project and changes resulting from defective plans and specification. Additionally, over-inspection and rejection of conforming work are other examples.
• Step 2-Give appropriate notice and get approval before performing the work.
• Step 3-Accumulate the necessary documentation to support the change that includes invoices, purchase orders, receipts plus daily logs, authorization for extra work, timesheets and pictures.
• Step 4-Price the change order accurately. Compare the line items in your change order with your internally developed list of frequently overlooked costs as presented earlier to assure no cost is missed.
• Step 5-Sell the claim to the owner. This step is not difficult if you and your customer agreed to the change order process at the beginning of the job.

With this model, you can begin to develop your own process. Yet, defining the process and putting it in a procedure manual is the simple part. Training your people to understand the policy and actively holding personnel accountable for its compliance is essential to make the process work and achieve the goal of pursuing and collecting change orders timely.
 

Construction Business Owner, May 2009