Change Orders and Construction – Best Practices to Go With the Flow

By Jaime Exley, CPA, Director of Accounting Solutions
ASL Construction Group

“The only constant in life is change” – Heraclitus

Every contractor understands the reality that construction projects are complex and have many moving parts. The ways in which a contractor manages changes during a project significantly impacts project profitability and cash flow. In many cases, construction companies’ reputations rise and fall with their ability to successfully navigate changes in project scope.

Best in class project managers take steps to ensure that changes are managed as smoothly as possible. They communicate with clients, subcontractors, and production crews early and often to make sure that everyone involved is working from the same playbook and that conflicts and misunderstandings are resolved. Keeping a watchful eye on the cost implications of changes in scope, Project Managers are positioned to directly impact a company’s bottom line.

Here we will discuss some best practices for the change order process and how they can contribute to successful projects.

  • Understand the Work

The period of time prior to a contract being finalized can be a golden opportunity to minimize the impact of future change orders on a project. By thoroughly reviewing drawings and schedules for feasibility, requests for information (RFIs) can be submitted prior to the contract being finalized. If issues are foreseen and resolved in the original contract scope, the risk of future cost overruns and disputes will be greatly reduced.

  • Know the Contract

Understanding the scope of work and timing is critical to avoid future misunderstandings. Frequently, conflicts arise when contractors or their clients make assumptions about a project without referring back to the contract terms. Field Supervisors who are familiar with the contract can prevent cost overruns for rework by adhering closely to design specifications and have the ability to recognize scope creep and raise issues before unbudgeted costs are incurred.

  • Manage Change

Profitable contractors navigate the change process to keep clients satisfied and protect their own bottom lines. As change requests come in, it’s important to communicate the estimated costs with clients early and ask for clarification in writing on open questions. In instances where work begins before a change order is signed, it’s important to obtain written notice from the client to proceed and track related costs as they are incurred. Documentation of costs incurred should be submitted daily to keep clients informed. Adhering to this process will be invaluable in the event that a claim or litigation becomes necessary.

Budgets should be revised as additions or reductions to project scope occur. Many profit fades result from a failure to estimate sub-contractor costs related to change orders so it’s important to anticipate their change order requests when revising budgets.

It’s also important to consider the cost impacts of schedule changes. Accelerated timelines can create additional costs for overtime and expedited delivery of materials. If a project’s schedule is significantly delayed, costs may be incurred for re-mobilizing equipment and inflation can impact labor and material costs.

At a project’s completion, unconditional final releases of lien rights should not be signed until all open change orders have been resolved.

  • Accounting for Open Change Orders

Uncertainty surrounding change order pricing can cause issues for companies that have WIP reporting requirements. U.S. GAAP uses the term “variable consideration” to refer to contract revenues that are not fixed at the time of the financial statements. This requires significant judgment on the part of management to estimate the current contract price. By being deliberate in making these estimates, companies can reduce the amount of profit fade in their WIP reporting which can help gain the confidence of sureties and lenders.

U.S GAAP details two methods for dealing with variable consideration 1) the expected value and 2) the most likely amount.

  1. Expected Value Method – For change requests in which the work is complete or is underway, the expected value method may be appropriate. Consider a scenario in which additional work has begun and costs are accumulating. The contractor has submitted a price for the work, which is pending acceptance from the client. At the time that the WIP is prepared, the forecasted costs at the completion of the additional work are $10,000. Pricing has been submitted to the client for $13,000, but the contractor believes that the final change order may be negotiated down to $11,500. Based on their history with the client, management determines that there is a 10% probability that the final price will only cover costs, a 20% chance that the full amount quoted will be accepted, and a 70% chance that a negotiated price of $11,500 will occur. Using a weighted average of these three outcomes, the WIP would reflect an estimated price for the change order of $11,650. Because the work is underway, the estimated costs of $10,000 is also added to the forecasted costs at completion on the WIP.
  2. Most Likely Amount Method – This method is less commonly used, but is appropriate when there are two possible outcomes for the final price.  In an instance where pricing has been submitted for additional work and the client may choose to either proceed or not, the contractor may choose to reflect the full price of the change or $0 based on their judgment.

Once either of these two methods has been applied, GAAP requires one additional consideration before adjusting the contract value. If management believes that it is probable that a significant reversal in revenue may occur in the future if the change order is recorded, the estimated price should be written down to the extent that a reversal is no longer probable.

Final Thoughts

Our goal in sharing these best practices is to provide tools to help you strengthen relationships with clients, trade partners, lenders and sureties. If there is any way that ASL can help you on that journey, please feel free to contact the experts in our Construction Group.