If you ask a group of contractors to list their biggest headaches, change orders will usually be near the top. Change orders are inevitable on most construction projects. How you manage them can mean the difference between a profitable project and a money-loser.
Know Your Contract
The first step in successfully handling change orders is to fully understand the change order process that is detailed in your contract. The language should be clear about who on the project owner’s team has the authority to assign additional work.
It should also indicate how and when your change order request should be submitted and processed. If anything is unclear, ask the project owner for written clarification.
Follow the Process
When out-of-scope work is assigned, make sure you follow the contract procedure to the letter—every time. If your request for a change order is denied and you decide to pursue a formal claim or litigation, the first thing you will need to do is show that you complied with the notification terms in the contract.
This discipline is especially important when dealing with a new customer or one with whom you have limited experience. Often, a project manager is under considerable pressure to “just get it done” and save the paperwork for later. But until the project owner has a well-established history of authorizing change orders reasonably and promptly, it is prudent to insist on a signed change order before any substantial work commences.
Get Everyone Involved
The principles that apply to general contractors submitting change order requests to project owners also apply when subcontractors submit their change order requests to the GC. In fact, you could argue that change orders are an even greater concern for subcontractors because they are usually the ones who will perform the requested work.
What’s more, even if a subcontractor follows the contract procedures for change order submissions to the letter, there’s still a risk the subcontractor will not get paid for the work if the general contractor drops the ball.
Most contracts between GCs and subs contain a “paid-when-paid” clause, so subcontractors should verify that their GC complies with contract terms to ensure successful handling of the change order. If there is any doubt, subs should ask for copies of all relevant change order requests the GC submits to the project owner.
Understand the Accounting
There is also a less obvious reason for strict adherence to contract terms: it can affect how the costs associated with change order-related work are reported and accounted for, which can directly affect your company’s bottom line.
According to Generally Accepted Accounting Principles (GAAP), you can recognize revenue from work that is billed to a change order only after the change order is approved. But it is common to begin incurring some costs for out-of-scope work even before a change order is approved.
How well you adhere to contract terms will affect how these costs are accounted for while you are awaiting approval. When contracts extend beyond a single reporting period, this can make a significant difference on your financial statements.
When you start to incur costs related to work that you think should be covered by a change order, GAAP rules allow you to record those costs as a prepaid expense—that is, as an asset on the balance sheet—only if you are adhering to your contract’s change order process and your company has a good record of getting approvals. You also need a strong cost identification system to segregate these costs into a separate account rather than just charging them to general job costs.
Above all, do not let change orders accumulate until the end of the project when you have less leverage. Getting change orders processed promptly takes discipline, but the alterative—not getting paid for legitimate work—is not acceptable.