Maryam Mirhadi, Ph.D, PMP
Owners typically have the contractual right to make changes to the scope of work outlined in contracts. Since these changes impact contracts’ scope of work and they potentially have time, cost, and productivity implications, it is important to give proper consideration to pricing change orders.
Pricing is either backward or forward. Backward pricing is used when the pricing is partly or wholly based on the actual cost of a work performed. Forward pricing, however, is based on the estimated cost of work that is yet to be performed.
If the forward pricing approach is used to price change orders or change order requests, the estimated cost of work is prepared based on the projected cost of materials, systems, products and permanent equipment needed to execute the work plus the costs of resources that need to be acquired in implementing the scope of work. The first category of costs is associated with those items that remain as part of the facility or the system being implemented whereas the second category of costs referenced above is associated with project resources (including workforce, temporary equipment, tools, and machinery) that do not remain in the project but are necessary to accomplish project activities. It is recommended that practitioners differentiate between these two categories of costs to ensure the cost of project deliverables can be differentiated from the resource costs.
It is important to account for projected levels of productivity in pricing change orders because the resource usage rate needed to perform a changed work may differ from the resource usage rates required to implement a work under normal circumstances in which no change is introduced. For example, if changing a scope of work adversely impacts labor productivity, the estimated usage rate of workforce originally used to estimate the unimpacted work does not necessarily suffice to complete a changed (i.e., impacted) scope of work. As such, in pricing change orders, the effects of change on the original scope of work need to be assessed to adjust the estimates.
One of the techniques that can be effective in assessing the impact of a changed work is assessing the project cost flow. Cost flow and cash flow are often used interchangeably. It is important, however, to identify the purpose each of these tools intends to serve. A cost flow diagram shows the budgeted amount of money that is needed over time to make progress as planned. A cash flow diagram, on the other hand, provides the estimated sums of money to which a contractor has access over time. Assessing the project cost flow can help analyze excessive costs and overruns by comparing the budgeted (i.e., time-phased estimates) cost of performing the changed work with the sums of money originally needed to make progress as planned. This assessment can help identify the adverse effect of the change on the resource costs needed over time.
This assessment can be insightful only if the cost flow and estimates are prepared at a sufficiently detailed level. Otherwise, they cannot provide an insight into the impact of change because of the lack of granularity of the pricing data available. Properly documenting the basis of estimates and using proper cost breakdown structures are two other important considerations in budget and cost flow documentation. Detailed budgets or cost flows are prepared by relying on certain assumptions and information available at the time of preparing these estimates. These assumptions and information should properly be documented in a document, entitled “basis of estimate”, for future references.
Per the Federal Acquisition Regulation (FAR), cost estimates used in government contracts have to be reasonable, allocable, and allowable. Moreover, pricing data must be current, accurate and complete. The following excerpts from the FAR define reasonableness, allocability, and allowability of costs:
- In defining the reasonableness of costs, Provision 31.201-3 of FAR states:
A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of a competitive business.
- In defining the allocability of costs, Provision 31.201-4 of FAR states:
A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship.
Per the FAR, a cost is allocable only if it:
(a) is incurred specifically for the contract; (b) benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or (c) is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.
- Per the FAR, the factors that need to be considered in determining whether a cost is allowable include the following:
- Reasonableness
- Allocability
- Standards promulgated by the CAS Board, if applicable; otherwise generally accepted accounting principles and practices appropriate to the particular circumstances.
- Terms of the contract
- Any limitations set forth in this subpart
It is also important to differentiate between direct and indirect costs in pricing change orders and determine which types of direct or indirect costs have to be included to accurately prepare cost estimates. Typical direct costs of executing construction activities include direct labor and workforce, equipment, material, and services provided to each project activity. Direct costs can be assigned to specific project activities whereas indirect costs are intended to cover overhead expenses that are needed to manage, administer and support the work. Indirect costs are not typically assignable to particular project activities. General conditions costs support various aspects of the work and they are typically assigned at the project level, not at the activity level. Therefore, they are typically considered among the indirect costs unless a different definition of indirect costs is adopted.
Based on what was discussed above, it is important to give proper consideration to pricing change orders. The proper use of pricing approaches including backward or forward pricing is the first step towards properly pricing change orders. The other considerations is to identify the time, cost, and productivity impacts of changes on the original scope of work. Cost flow diagrams can assist in better identifying the impact of change on a project cost, schedule, and productivity. It is also important to ensure proper pricing and estimating practices are used to ensure estimates are reasonable, allocable, and allowable. An effective use of cost engineering techniques throughout the process plays an important role to ensure the estimates prepared for change orders are current, accurate and complete.
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