Keep Change Orders from Becoming Claims

Does this story sound familiar? A contractor is behind schedule on a project. The owner is pressuring the general contractor (GC) to complete the job on time. The GC is pressuring the subcontractors and threatening to pass on penalties for late completion. Contract days are running thin. … Then, a change order! What appears to be a saving grace that will not only give the contractor additional days to complete the work, but also an opportunity to improve the margins on the job, turns into a dispute between parties after the rush to complete the work. The result: lost profits for all parties, damaged business relationships, and disruption of and additional losses to other jobs underway.

Change orders, that is, modifications to an original contract, are a common occurrence in construction projects. While they can be necessary to accommodate required adjustments, and can also be profitable additions to the contract scope, they can sometimes escalate into costly and time-consuming claims, impacting project timelines, budgets, and relationships. To mitigate the risk of change orders turning into claims, construction companies need to adopt proactive practices that promote effective communication, documentation, and collaboration.

Clear and Transparent Communication

Effective communication is the foundation for preventing change orders from becoming claims. Construction companies should establish clear lines of communication among all project stakeholders, including owners, contractors, subcontractors, and design professionals. Regular project meetings, progress reports, and open channels of communication help ensure that everyone is aware of project updates, potential changes, and their implications. Typically, internal meetings should be held weekly between project manager, superintendents, and their crews while a monthly meeting should update the accounting department and the executive team on project status. These meetings serve as a springboard to monthly updates with customers to make sure that everyone is on the same page when it comes to the progress of work, and just as important, any known or potential speed bumps that could impact job completion. Transparent communication fosters collaboration and buy-in and minimizes misunderstandings that can lead to disputes later on.

Thorough Project Documentation

Comprehensive and accurate project documentation is crucial in preventing change orders from becoming claims. Companies should maintain a robust system for recording and tracking all project-related information, including original plans, specifications, contracts, correspondence, meeting minutes, and change-order requests. Proper documentation includes signatures of authorized personnel on both sides of the contract. Documentation establishes a paper trail, ensuring that all parties are aware of agreed-upon changes, their associated costs, and the responsibilities of each contracted party. It also helps resolve disputes by providing evidence of discussions, approvals, and any adjustments made throughout the project. Without adequate documentation, the project wrap-up phase could turn into a long, drawn-out process that eats away at a contractor’s gross margins.

Timely Change-Order Management

Timely management of change orders is essential to prevent claims from arising. Construction companies should establish a systematic process for reviewing, evaluating, and responding to change-order requests promptly. The process should include proper documentation, cost analysis, and evaluation of potential impacts on the project timeline. Regular communication and collaboration with stakeholders during this phase are crucial to reach consensus on change-order details, including pricing, time extensions, and other necessary adjustments. Many contractors tend to just forge ahead on a project with the expectation that everything will work itself out later when change orders arise. In some cases, a strong economic environment and long-standing relationships between the contracted parties may make that the case, but without a system in place to review, evaluate, and respond to change orders in a timely manner, such a laissez-faire approach is likely to burn a contractor at some point.

Accurate Cost Estimation

Estimating costs accurately is also vital to keeping change orders from escalating into claims. Construction companies should invest the necessary time and effort into conducting detailed cost assessments for each change order. Of course, this includes evaluating the direct costs associated with labor (including supervision of others’ work), materials, equipment rental/usage, and subcontractors. But many contractors fail to consider the impact of indirect costs such as overhead and project management expenses when evaluating change orders. Furthermore, a thorough analysis of costs will include the consideration of using subcontractors to perform some or all the work under the change order. The availability of in-house resources versus subcontractor crews could have a substantial impact on the cost estimation of change orders as well as the project completion date, which could impact performance bonuses and/or liquidated damages provisions in the contract. Comprehensive cost estimation helps set realistic expectations and reduces the likelihood of disputes arising due to cost discrepancies.

Constructive Negotiation and Mediation

A contractor’s first step to adequately protecting their business occurs before a contract is signed. If a contractor does not have in-house legal counsel, they should retain the services of an attorney experienced in construction contracts. This relationship helps contractors avoid onerous contract provisions that could create a situation where one job going wrong could lead to the shutdown of operations, loss of employment for workers, and the deterioration of lifelong investments for owners. Even in less severe circumstances, it is in everybody’s interest to avoid long, contentious legal battles where attorneys’ fees add up quickly.

When disagreements arise, construction companies should adopt a proactive approach by engaging in constructive negotiation and mediation. Rather than immediately resorting to legal action, parties should explore alternative dispute resolution methods, such as mediation or arbitration, to find mutually beneficial solutions. Mediation can facilitate open dialogue, allowing all parties to voice their concerns and reach a compromise. Arbitration allows a third-party to rule on the matter, which is less ideal than a mediated settlement where the two conflicted parties must come to a mutually agreed-upon outcome, but is significantly less costly than going to court. Too often, when legal action is used impulsively, contractors end up incurring legal costs that approximate the amount of the dispute. In these cases, the contractor is no better off monetarily, and likely left with a soured business relationship that could eliminate any future opportunities to collaborate. Constructive negotiation and mediation help preserve relationships, reduce costs, and maintain project progress while avoiding the time-consuming and adversarial nature of claims.

Continuous Risk Management

Effective risk management is crucial throughout the construction project lifecycle to prevent change orders from becoming claims. Construction companies should identify potential risks and uncertainties early on, develop contingency plans, and implement proactive measures to mitigate risks. This includes conducting thorough site investigations, anticipating design changes, considering unforeseen circumstances, and maintaining appropriate insurance coverage. These steps should be revisited throughout the project, not just at its inception. In many cases, project managers are not effective in balancing these responsibilities with cost containment, job progress, subcontractor oversight, and customer satisfaction over the course of a job. A dedicated risk manager can help make sure that there are periodic reviews of job site safety, which can save the company significant amounts in insurance premiums and claims, and also work with the project managers across jobs to identify risks that if left unaddressed could turn into costly claims. By being proactive in risk management, construction companies can minimize the occurrence and impact of change orders and subsequent claims.

Preventing change orders from escalating into claims requires proactive practices, effective communication, and thorough documentation throughout the construction project. By fostering clear communication, maintaining comprehensive project documentation, managing change orders in a timely manner, ensuring accurate cost estimation, engaging in constructive negotiation and mediation, and implementing continuous risk management, construction companies can significantly reduce the likelihood of change orders becoming claims. Adopting these proactive strategies promotes a collaborative and efficient construction process, enhancing project success, client satisfaction, and overall profitability.

About the Author(s)
Brandon is a Principal in the Naples, Florida office of HBK CPAs & Consultants and has been with the firm since 2016. He is the Florida Regional Director of HBK Construction Solutions, a team of specialists focused on contractors and their unique business needs.
Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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