Overhead – You Can’t Do Business Without It – Lexology
Despite sometimes being referred to as an indirect or hidden cost, overhead costs are real and can be substantial. Most overhead costs are time-related, meaning that these costs are incurred throughout the planned duration of a project and continue to be incurred if a project is delayed. As a result, project delays often result in contractor claims for extended and unabsorbed overhead.
Although recovery of overhead costs is arguably required if that contractor is to be made whole, carefully worded contract provisions, case law, and a contractor’s chosen accounting method can all dictate actual recovery. This article provides an overview of such considerations with the goal of providing points to assist with, or defeat, recovery of overhead costs.
Field and Home Office Overhead
Construction company overhead includes both field overhead and home office overhead. Field overhead includes the costs of employees, facilities and equipment that support the project but are not directly involved in building the project; for example, upper-level project supervision, on-site engineering, accounting, human resources, clerical personnel, and safety and medical facilities and personnel. Most field overhead costs such as salaries, utilities, and trailer rental are time related. But some, such as permits, mobilization, and demolition, are not. When change orders extend the project time, field overhead can be calculated as a daily rate or estimated as a percentage of direct costs.
Home office overhead, as the name implies, includes the contractor’s home office and other costs, such as insurance, taxes, and depreciation that are necessary to support the contractor’s operation as a whole. Sound business practice requires a contractor to include a portion of its home office overhead cost in its bid or proposal for individual projects. If a project is delayed, the delay may prevent the contractor from taking on new work needed to cover or absorb its home office costs. When this occurs, the contractor will experience unabsorbed home office overhead. For purposes of pricing changes, home office overhead can also be calculated as a daily rate or charged as a percentage of direct cost.
Despite the essential nature of overhead costs, contract terms can severely limit a contractor’s recovery of field or home office overhead, or both. Examples include changes, differing site conditions, suspension of work, no-damages-for-delay, waiver of consequential damages, and termination provisions.
An initial step in assessing recoverability is to determine whether an applicable contract term specifically addresses field versus home office overhead or even differentiates between the two. For example, a change order clause may provide for a stated percentage markup, usually between 5% and 10%, on direct costs. Deceptively simple, such a provision can be interpreted to encompass both field and home office overhead as well as profit. A contractor may waive recovery of field office and home office overhead by executing such a change order. The contractor’s situation is worsened if direct costs of the change order are low—meaning a low multiplier for the stated percentage—but the change causes a long delay resulting in both extended field overhead and unabsorbed home office overhead. In such a case, the contractor may try to price field and home office overhead separately before adding the percentage markup, but the owner may object to paying a markup on overhead. Or the contractor may include a reservation of rights to recover overhead when the actual delay impact of the change is determined.
For contractors it is important to scrutinize contract limitations and avoid pricing change orders and claims in such a way as to trigger the limitations. For example, if the contract has a no damage for delay clause, it is better to request a change order than to submit a delay claim. Owners, on the other hand, will want to be vigilant to enforce bargained-for limitations on overhead recovery.
Cost Accounting Methods
Absent an express contract prohibition, contractors can legitimately use either a percentage-based or daily rate-based overhead amount to price changes and claims. More aggressive contractors may seek to vary the method used based on the situation. As is discussed above, a percentage markup is unfavorable if the change amount is small and the delay long, but favorable if the change is large and the delay negligible. This strategy will not work for federal contractors. Case law, FAR 31.105(d)(3), and DCAA’s audit direction severely limit a contractor’s recovery if the contractor seeks to use both methods or assert one method over another when advantageous to the contractor. Outside of the federal contracts arena, a sophisticated owner may incorporate related concepts into applicable contract provisions, to limit a contractor’s recovery based on the circumstances of an individual change.
Between extended field overhead and unabsorbed home office overhead, the latter is generally more difficult to prove. This is inherent in the indirect nature of home office overhead. For this reason, formulas are often used to quantify home office overhead.
Eichleay and Other Formulas
The Eichleay formula stems from a 1960s federal government contracts decision and is mandatory for use on federal contract claims. In brief, the Eichleay formula allocates home office overhead to a project based on the ratio of the contract amount to the contractor’s total home office overhead. The allocable amount is divided by total days of performance to obtain a daily rate which is then multiplied by the number of delay days to arrive at the recoverable amount. Since 1960, the additional requirements of standby and lack of replacement work have been imposed on contractors seeking recovery. The Eichleay formula has been adopted by some courts and entirely rejected by other courts.
Beyond Eichleay, there are at least seven other formulas used in the U.S. and Canada, carrying names such as Allegheny, Canadian, Carteret, Emden, Ernstrom, Hudson, and Manshul. The intricacies of each of these formulas, and their acceptance in specific jurisdictions, is beyond the scope of this article. They are mentioned to show that home office overhead can be quantified in different ways that often result in significantly different amounts. It should not be surprising then to a sophisticated contractor, that a contractually required method of calculating home office overhead for changes may drastically impact a contractor’s recovery.
While understanding the intricacies of field office and home office overhead is essential, neither an owner nor a contractor can lose sight of the need to prove that the other party caused a delay to the critical path and caused the complained of damages. Stated differently, both entitlement to overhead as well as the calculation of overhead must be emphasized in claim preparation and well before that stage, in project document management and contract negotiation.